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Google 10-Q 2011 Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
FORM 10-Q
(Mark One)
For the quarterly period ended June 30, 2011 OR
For the transition period from to Commission file number: 000-50726
Google Inc. (Exact name of registrant as specified in its charter)
1600 Amphitheatre Parkway Mountain View, CA 94043 (Address of principal executive offices, including zip code) (650) 253-0000 (Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨ Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x At July 21, 2011, there were 254,219,910 shares of Google’s Class A common stock outstanding and 68,667,853 shares of Google’s Class B common stock outstanding.
Table of ContentsForm 10-Q For the Quarterly Period Ended June 30, 2011 TABLE OF CONTENTS
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Table of ContentsNOTE ABOUT FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements include, among other things, statements regarding:
as well as other statements regarding our future operations, financial condition and prospects, and business strategies. Forward-looking statements may appear throughout this report, including without limitation, the following sections: Part I, Item 2 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Part II, Item 1A “Risk Factors.” Forward-looking statements generally can be identified by words such as “anticipates,” “believes,” “estimates,” “expects,” “intends,” “plans,” “predicts,” “projects,” “will be,” “will continue,” “will likely result,” and similar expressions. These forward-looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, which could cause our actual results to differ materially from those reflected in the forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in this Quarterly Report on Form 10-Q, and in particular, the risks discussed under the caption “Risk Factors” in Part II, Item 1A and those discussed in other documents we file with the Securities and Exchange Commission (SEC). We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements, except as required by law. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.
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Table of ContentsAs used herein, “Google,” “we,” “our,” and similar terms include Google Inc. and its subsidiaries, unless the context indicates otherwise. “Google” and other trademarks of ours appearing in this report are our property. This report may contain additional trade names and trademarks of other companies. We do not intend our use or display of other companies’ trade names or trademarks to imply an endorsement or sponsorship of us by such companies, or any relationship with any of these companies.
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CONSOLIDATED BALANCE SHEETS (In millions, except share and par value amounts which are reflected in thousands, and par value per share amounts)
See accompanying notes.
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Table of ContentsCONSOLIDATED STATEMENTS OF INCOME (In millions, except per share amounts)
See accompanying notes.
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Table of ContentsCONSOLIDATED STATEMENTS OF CASH FLOWS (In millions)
See accompanying notes.
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Table of ContentsNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1. Google Inc. and Summary of Significant Accounting Policies Nature of Operations We were incorporated in California in September 1998. We were re-incorporated in the State of Delaware in August 2003. We generate revenue primarily by delivering relevant, cost-effective online advertising. Basis of Consolidation The consolidated financial statements include the accounts of Google Inc. and our wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated. Unaudited Interim Financial Information The accompanying Consolidated Balance Sheet as of June 30, 2011, the Consolidated Statements of Income for the three and six months ended June 30, 2010 and 2011, and the Consolidated Statements of Cash Flows for the six months ended June 30, 2010 and 2011 are unaudited. These unaudited interim consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP). In our opinion, the unaudited interim consolidated financial statements include all adjustments of a normal recurring nature necessary for the fair presentation of our financial position as of June 30, 2011, our results of operations for the three and six months ended June 30, 2010 and 2011, and our cash flows for the six months ended June 30, 2010 and 2011. The results of operations for the three and six months ended June 30, 2011 are not necessarily indicative of the results to be expected for the year ending December 31, 2011. These unaudited interim consolidated financial statements should be read in conjunction with the consolidated financial statements and related notes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 filed with the SEC on February 11, 2011. Use of Estimates The preparation of consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported and disclosed in the financial statements and the accompanying notes. Actual results could differ materially from these estimates. On an ongoing basis, we evaluate our estimates, including those related to the accounts receivable and sales allowances, fair values of financial instruments, intangible assets and goodwill, useful lives of intangible assets and property and equipment, fair values of stock-based awards, income taxes, and contingent liabilities, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Recent Accounting Pronouncements In May 2011, the Financial Accounting Standards Board (FASB) issued a new accounting standard update, which amends the fair value measurement guidance and includes some enhanced disclosure requirements. The most significant change in disclosures is an expansion of the information required for Level 3 measurements based on unobservable inputs. The standard is effective for fiscal years beginning after December 15, 2011. We will adopt this standard in the first quarter of 2012 and are currently evaluating its impact on our financial statements and disclosures. In June 2011, the FASB issued a new accounting standard, which eliminates the current option to report other comprehensive income and its components in the statement of stockholders’ equity. Instead, an entity will be required to present items of net income and other comprehensive income in one continuous statement or in two separate, but consecutive, statements. The standard is effective for fiscal years beginning after December 15, 2011. We will adopt this standard in the first quarter of 2012.
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Table of ContentsNote 2. Net Income Per Share of Class A and Class B Common Stock The following table sets forth the computation of basic and diluted net income per share of Class A and Class B common stock (in millions, except share amounts which are reflected in thousands and per share amounts):
The net income per share amounts are the same for Class A and Class B common stock because the holders of each class are legally entitled to equal per share distributions whether through dividends or in liquidation.
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Table of ContentsNote 3. Cash and Investments Cash, cash equivalents, and marketable securities consist of the following (in millions):
The following table summarizes unrealized gains and losses related to our investments in marketable securities designated as available-for-sale (in millions):
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Gross unrealized gains and losses on cash equivalents were not material at December 31, 2010 and June 30, 2011. We recognized gross realized gains of $53 million and $81 million for the three and six months ended June 30, 2010. We recognized gross realized gains of $94 million and $135 million for the three and six months ended June 30, 2011. Gross realized losses were not material for the three and six months ended June 30, 2010. We recognized gross realized losses of $19 million and $33 million for the three and six months ended June 30, 2011. We determine realized gains and losses on the sale of marketable securities on a specific identification method, and we reflect such gains and losses as a component of interest and other income, net, in the accompanying Consolidated Statements of Income. The following table summarizes the estimated fair value of our investments in marketable debt securities, designated as available-for-sale and classified by the contractual maturity date of the security (in millions):
The following tables present fair values and gross unrealized losses for those investments that were in an unrealized loss position as of December 31, 2010 and June 30, 2011 aggregated by investment category and the length of time that individual securities have been in a continuous loss position (in millions):
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As of December 31, 2010, we did not have any investments in marketable securities that were in an unrealized loss position for a period of 12 months or greater. As of June 30, 2011, our investments in marketable securities that were in an unrealized loss position for a period of 12 months or greater was not material. Securities Lending Program From time to time, we enter into securities lending agreements with financial institutions to enhance investment income. We loan selected securities which are secured by collateral in the form of cash or securities. Cash collateral is invested in reverse repurchase agreements. We classify loaned securities as cash equivalents or marketable securities on the accompanying Consolidated Balance Sheets. We record the cash collateral as an asset with a corresponding liability. We classify reverse repurchase agreements maturing within three months as cash equivalents and those longer than three months as receivable under reverse repurchase agreements on the accompanying Consolidated Balance Sheets. For lending agreements collateralized by securities, we do not record an asset or liability as we are not permitted to sell or repledge the associated collateral. Note 4. Debt Short-Term Debt We have a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from the commercial paper program are used for general corporate purposes. As of June 30, 2011, we had $749 million of commercial paper outstanding recorded as short-term debt, with a weighted-average interest rate of 0.4% that matures at various dates through November 2011. The estimated fair value of the commercial paper approximates its carrying value. In conjunction with this program, we established a $3.0 billion revolving credit facility expiring on June 30, 2013. The interest rate for the credit facility is determined based on a formula using certain market rates. As of June 30, 2011, we were in compliance with the financial covenant in the credit facility. No amounts were outstanding under the credit facility as of June 30, 2011. Additionally, as of June 30, 2011, we had $468 million outstanding under a secured promissory note with an interest rate of 1.0% that matures in December 2011. Proceeds of this note were used for the acquisition of an office building in New York City. Long-Term Debt In May 2011, we issued $3.0 billion of unsecured senior notes in three tranches as described in the table below (collectively the Notes) (in millions).
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Table of ContentsInterest on the Notes is payable semi-annually in arrears on May 19 and November 19 of each year. We may redeem the Notes at any time in whole or from time to time in part at specified redemption prices. We are not subject to any financial covenants under the Notes. We used the net proceeds from the sale of the Notes to repay a portion of our outstanding commercial paper and for general corporate purposes. The total estimated fair value of our long-term debt was approximately $3 billion, which is based on quoted prices for our publicly-traded debt as of June 30, 2011. Note 5. Derivative Financial Instruments We enter into foreign currency contracts with financial institutions to reduce the risk that our cash flows and earnings will be adversely affected by foreign currency exchange rate fluctuations. We use exchange-traded interest rate futures contracts to hedge interest rate exposures on certain fixed income securities. Our program is not designated for trading or speculative purposes. We recognize derivative instruments as either assets or liabilities on the accompanying Consolidated Balance Sheets at fair value. We record changes in the fair value (i.e., gains or losses) of the derivatives in the accompanying Consolidated Statements of Income as interest and other income, net, as part of revenues, or to accumulated other comprehensive income (AOCI) on the accompanying Consolidated Balance Sheets. Cash Flow Hedges We use options designated as cash flow hedges to hedge certain forecasted revenue transactions denominated in currencies other than the U.S. dollar. We initially report any gain on the effective portion of a cash flow hedge as a component of AOCI and subsequently reclassify to revenues when the hedged revenues are recorded or as interest and other income, net, if the hedged transaction becomes probable of not occurring. At June 30, 2011, the effective portion of our cash flow hedges before tax effect was $11 million, of which $8 million is expected to be reclassified from AOCI to revenues within the next 12 months. We recognize any gain after a hedge is de-designated or related to an ineffective portion of a hedge in interest and other income, net, immediately. Further, we exclude the change in the time value of the options from our assessment of hedge effectiveness. We record the premium paid or time value of an option whose strike price is equal to or greater than the market price on the date of purchase as an asset. Thereafter, we recognize any change to this time value in interest and other income, net. The notional principal of foreign exchange contracts to purchase U.S. dollars with Euros was €3.0 billion (or approximately $4.1 billion) and €2.9 billion (or approximately $3.9 billion) at December 31, 2010 and June 30, 2011; the notional principal of foreign exchange contracts to purchase U.S. dollars with British pounds was £1.5 billion (or approximately $2.3 billion) and £1.3 billion (or approximately $2.0 billion) at December 31, 2010 and June 30, 2011; and the notional principal of foreign exchange contracts to purchase U.S. dollars with Canadian dollars was C$407 million (or approximately $382 million) and C$324 million (or approximately $315 million) at December 31, 2010 and June 30, 2011. These foreign exchange options have maturities of 36 months or less. We have not designated any other foreign exchange contracts as cash flow hedges. Fair Value Hedges We use forward contracts designated as fair value hedges to hedge foreign currency risks for our investments denominated in currencies other than the U.S. dollar. Gains and losses on these contracts are recognized in interest and other income, net, along with the offsetting losses and gains of the related hedged items. We exclude changes in the time value for forward contracts from the assessment of hedge effectiveness and recognize them in interest and other income, net. The notional principal of foreign exchange contracts to purchase U.S. dollars with foreign currencies was $787 million and $1.1 billion at December 31, 2010 and June 30, 2011. Other Derivatives Other derivatives not designated as hedging instruments consist primarily of forward contracts that we use to hedge intercompany balances and other monetary assets or liabilities denominated in currencies other than the local currency of a subsidiary. We recognize gains and losses on these contracts as well as the related costs in interest and other income, net, along with the gains and losses of the related hedged items. The notional principal of foreign exchange contracts to purchase U.S. dollars with foreign currencies was $1.0 billion and $1.6 billion at December 31, 2010 and June 30, 2011.
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Table of ContentsThe notional principal of foreign exchange contracts to sell U.S. dollars for foreign currencies was $84 million and $522 million at December 31, 2010 and June 30, 2011. The notional principal of foreign exchange contracts to purchase Euros with other currencies was €991 million (or approximately $1.3 billion) and €750 million (or approximately $1.1 billion) at December 31, 2010 and June 30, 2011. The notional principal of foreign exchange contracts to sell Euros for other foreign currencies was €6 million (or approximately $8 million) at December 31, 2010 and no such contracts were outstanding at June 30, 2011. We also use exchange-traded interest rate futures contracts which are not designated as hedging instruments to hedge interest rate risks on certain fixed income securities. We recognize gains and losses on these contracts as well as the related costs in interest and other income, net. The gains and losses are generally economically offset by unrealized gains and losses in the underlying available-for-sale securities, which are recorded as a component of AOCI until the securities are sold or other-than-temporarily impaired, at which time the amounts are moved from AOCI into interest and other income, net. As of June 30, 2011, the total notional amounts of interest rate futures contracts outstanding were $200 million. At December 31, 2010 and June 30, 2011, the fair values of our outstanding derivative instruments were (in millions):
The effect of derivative instruments in cash flow hedging relationship on income and other comprehensive income for the three and six months ended June 30, 2010 and 2011 is summarized below (in millions):
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The effect of derivative instruments in fair value hedging relationship on income for the three and six months ended June 30, 2010 and 2011 is summarized below (in millions):
The effect of derivative instruments not designated as hedging instruments on income for the three and six months ended June 30, 2010 and 2011 is summarized below (in millions):
Note 6. Fair Value Measurements We measure our cash equivalents, marketable securities, auction rate securities (ARS), and foreign currency and interest rate derivative contracts at fair value. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability. A three-tier fair value hierarchy is established as a basis for considering such assumptions and for inputs used in the valuation methodologies in measuring fair value: Level 1 - Observable inputs that reflect quoted prices (unadjusted) for identical assets or liabilities in active markets. Level 2 - Include other inputs that are directly or indirectly observable in the marketplace. Level 3 - Unobservable inputs that are supported by little or no market activities.
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Table of ContentsThe fair value hierarchy also requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. We classify our cash equivalents and marketable securities within Level 1 or Level 2. This is because we value our cash equivalents and marketable securities using quoted market prices or alternative pricing sources and models utilizing market observable inputs. We classify our investments in ARS within Level 3 because they are valued using valuation techniques (see below). Some of the inputs to these models are unobservable in the market and are significant. We classify our foreign currency and interest rate derivative contracts within Level 2 as the valuation inputs are based on quoted prices and market observable data of similar instruments. Assets and liabilities measured at fair value on a recurring basis are summarized below (in millions):
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At June 30, 2011, we held $126 million of ARS. Historically, these securities have provided liquidity through a Dutch auction process. However, these auctions began to fail in the first quarter of 2008. To estimate their fair values at June 30, 2011, we used a discounted cash flow model based on estimated interest rates, timing and amount of cash flows, the credit quality of the underlying securities, and illiquidity considerations. Specifically, we estimated the future cash flows of our ARS over the expected workout periods using a projected weighted-average interest rate of 2% per annum, which is based on the forward swap curve at the end of June 2011 plus any additional basis points currently paid by the issuers assuming these auctions continue to fail. A discount factor was applied over these estimated cash flows of our ARS, which is calculated based on the interpolated forward swap curve adjusted by up to 1,250 basis points to reflect the current market conditions for instruments with similar credit quality at the date of the valuation and further adjusted by up to 400 basis points to reflect a discount for the liquidity risk associated with these investments due to the lack of an active market. At June 30, 2011, the estimated fair value of these ARS was $19 million less than their costs. As we have no intent to sell these ARS and it is more likely than not that we will not be required to sell these ARS prior to recovery of our entire cost basis, we concluded the decline in the fair value was temporary and recorded the unrealized loss to AOCI on the accompanying Consolidated Balance Sheet at June 30, 2011. To the extent we determine that any impairment is other-than-temporary, we would record a charge to earnings. In addition, we have concluded that the auctions for these securities may continue to fail for at least the next 12 months and as a result, we classified them as non-current assets on the accompanying Consolidated Balance Sheet at June 30, 2011.
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Table of ContentsThe following table presents a reconciliation for our ARS measured and recorded at fair value on a recurring basis, using significant unobservable inputs (Level 3) for the three and six months ended June 30, 2010 and 2011 (in millions):
Note 7. Property and Equipment Property and equipment consist of the following (in millions):
Note 8. Acquisitions On April 12, 2011, we completed the acquisition of ITA Software, Inc. (ITA), a privately-held flight information software company, for $676 million in cash.
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Table of ContentsDuring the six months ended June 30, 2011, we completed 29 other acquisitions and purchases of intangible assets for a total cash consideration of approximately $260 million. These acquisitions were not material individually or in aggregate. The following table summarizes the allocation of the purchase price for all the acquisitions completed during the six months ended June 30, 2011 (in millions):
For all acquisitions completed during the six months ended June 30, 2011, patents and developed technology have a weighted-average useful life of 6.9 years, customer relationships have a weighted-average useful life of 7.9 years and trade names and other have a weighted-average useful life of 3.2 years. The amount of goodwill expected to be deductible for tax purposes is $2 million. Note 9. Goodwill and Other Intangible Assets The changes in the carrying amount of goodwill for the six months ended June 30, 2011 are as follows (in millions, unaudited):
Information regarding our acquisition-related intangible assets that are being amortized is as follows (in millions):
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Table of ContentsAmortization expense of acquisition-related intangible assets for the three and six months ended June 30, 2010 was $70 million and $133 million and for the three and six months ended June 30, 2011 was $106 million and $201 million. As of June 30, 2011, expected amortization expense for acquisition-related intangible assets for each of the next five years and thereafter is as follows (in millions, unaudited):
Note 10. Interest and Other Income, Net The components of interest and other income, net are as follows (in millions):
Note 11. Comprehensive Income The changes in the components of comprehensive income are as follows (in millions):
The components of AOCI are as follows (in millions):
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Table of ContentsNote 12. Contingencies Legal Matters We have had patent, copyright, and trademark infringement lawsuits filed against us claiming that certain of our products, services, and technologies, including Android, Google WebSearch, Google AdWords, Google AdSense, Google Books, Google News, Google Image Search, Google Chrome, Google Talk, Google Voice, and YouTube, infringe the intellectual property rights of others. Adverse results in these lawsuits may include awards of substantial monetary damages, costly royalty or licensing agreements, or orders preventing us from offering certain features, functionalities, products, or services, and may also cause us to change our business practices, and require development of non-infringing products or technologies, which could result in a loss of revenues for us and otherwise harm our business. In addition, many of our agreements with our customers and partners require us to indemnify them for certain intellectual property infringement claims against them, which would increase our costs as a result of defending such claims, and may require that we pay significant damages if there were an adverse ruling in any such claims. Furthermore, such customers and partners may discontinue the use of our products, services, and technologies, as a result of injunctions or otherwise, which could result in loss of revenues and adversely impact our business. We are also regularly involved in other claims, suits, government investigations, and proceedings arising from the ordinary course of our business, including actions with respect to intellectual property claims, competition and antitrust matters (such as the pending investigations by the U.S. Federal Trade Commission and the European Commission), privacy matters, tax matters, labor and employment claims, commercial claims, as well as actions involving content generated by our users, and other matters. We have recorded liabilities for certain of these outstanding legal matters. Certain of these matters assert claims for substantial or indeterminate damages. We record a provision for a liability when we believe that it is both probable that a liability has been incurred, and the amount can be reasonably estimated. We evaluate, on a monthly basis, developments in our legal matters that could affect the amount of liability that has been previously accrued, and make adjustments as appropriate. Significant judgment is required to determine both probability and the estimated amount. Such legal matters are inherently unpredictable and subject to significant uncertainties, some of which are beyond our control. In all of our outstanding legal matters in which we have not made an accrual, management is unable to estimate a range of reasonably possible loss due to various reasons, including, among others: (1) that the proceedings are in early stages, (2) that there is uncertainty as to the outcome of pending appeals, motions, or settlements, (3) that there are significant factual issues to be resolved, and (4) that there are novel legal issues presented. While the results of such claims, suits, government investigations, and proceedings are not reasonably estimable at this time, based on our current knowledge, we believe that the final outcome of the matters discussed above, including liabilities in excess of the amounts accrued, if any, will not, individually or in the aggregate, have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. However, in light of the uncertainties involved in such matters, the final outcome of a particular matter could have a material adverse effect on our results of operations or cash flows in a particular period. EPA Investigation In February 2009, we learned of a U.S. Environmental Protection Agency (EPA) investigation into an alleged release of refrigerant at one of our smaller data center facilities, which we acquired from DoubleClick, and the accuracy of related statements and records. We are cooperating with the EPA and have provided documents and other materials. The EPA investigation could result in fines, civil or criminal penalties, or other adverse consequences. Since there are significant factual issues to be resolved, we cannot estimate a reasonable range of possible loss at this time. We believe the final outcome of this matter, including any liability in excess of the amount accrued, if any, will not have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows. Department of Justice Investigation (Advertising) In May 2011, in connection with a potential resolution of an investigation by the United States Department of Justice into the use of Google advertising by certain advertisers, we accrued $500 million for the three-month period ended March 31, 2011. Although we cannot predict the final outcome of this matter, we believe that any liability in excess of the amount accrued will not have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows.
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Table of ContentsIncome Taxes We are under audit by the Internal Revenue Service (IRS) and various other tax authorities. We have reserved for potential adjustments to our provision for income taxes that may result from examinations by, or any negotiated agreements with, these tax authorities, and we believe that the final outcome of these examinations or agreements will not have a material effect on our results of operations. If events occur which indicate payment of these amounts is unnecessary, the reversal of the liabilities would result in the recognition of tax benefits in the period we determine the liabilities are no longer necessary. If our estimates of the federal, state, and foreign income tax liabilities are less than the ultimate assessment, a further charge to expense would result. Note 13. Stockholders’ Equity The following table presents the weighted-average assumptions used to estimate the fair values of the stock options granted in the periods presented:
The following table summarizes the activities for our options for the six months ended June 30, 2011:
The following table summarizes additional information regarding outstanding, exercisable, and vested and exercisable stock options and warrants at June 30, 2011:
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Table of ContentsThe above tables include approximately 0.9 million warrants held by selected financial institutions that were options purchased from employees under our Transferable Stock Option (TSO) program, with a weighted-average exercise price of $318.54 and a weighted-average remaining life of 0.9 years. The total grant date fair value of stock options vested during the three and six months ended June 30, 2010 was $91 million and $206 million. The total grant date fair value of stock options vested during the three and six months ended June 30, 2011 was $123 million and $250 million. The aggregate intrinsic value of all options and warrants exercised during the three and six months ended June 30, 2010 was $86 million and $133 million. The aggregate intrinsic value of all options and warrants exercised during the three and six months ended June 30, 2011 was $68 million and $313 million. These amounts do not include the aggregate sales price of options sold under our TSO program. During the six months ended June 30, 2011, the number of shares underlying TSOs sold to selected financial institutions under the TSO program was 25,832 at a total value of $4 million, or an average price of $150.51 per share, including an average premium of $18.26 per share. The premium is calculated as the difference between (a) the sale price of the TSO and (b) the intrinsic value of the TSO, which we define as the excess, if any, of the price of our Class A common stock at the time of the sale over the exercise price of the TSO. As of June 30, 2011, there was $777 million of unrecognized compensation cost related to outstanding employee stock options. This amount is expected to be recognized over a weighted-average period of 2.4 years. To the extent the actual forfeiture rate is different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations. The following table summarizes the activities for our unvested restricted stock units (RSUs) and restricted shares for the six months ended June 30, 2011:
As of June 30, 2011, there was $4,081 million of unrecognized compensation cost related to employee unvested RSUs and restricted shares. This amount is expected to be recognized over a weighted-average period of 3.2 years. To the extent the actual forfeiture rate is different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations. Note 14. Income Taxes We are subject to income taxes in the U.S. and numerous foreign jurisdictions. Significant judgment is required in evaluating our uncertain tax positions and determining our provision for income taxes. Our total unrecognized tax benefits as of December 31, 2010 and June 30, 2011 were $1,140 million and $1,397 million. Our total unrecognized tax benefits that, if recognized, would affect our effective tax rate were $951 million and $1,183 million as of December 31, 2010 and June 30, 2011. Our existing tax positions will continue to generate an increase in liabilities for unrecognized tax benefits. Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates. Our effective tax rate could also fluctuate due to the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign
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Table of Contentsexchange risk management program, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. Note 15. Information about Geographic Areas Our chief operating decision-makers (i.e., chief executive officer and certain of his direct reports) review financial information presented on a consolidated basis, accompanied by disaggregated information about revenues by geographic region for purposes of allocating resources and evaluating financial performance. There are no segment managers who are held accountable by our chief operating decision-makers, or anyone else, for operations, operating results, and planning for levels or components below the consolidated unit level. Accordingly, we consider ourselves to be in a single reporting segment and operating unit structure. Revenues by geography are based on the billing addresses of our customers. The following table sets forth revenues and long-lived assets by geographic area (in millions):
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The following discussion and analysis of our financial condition and results of operations should be read together with our consolidated financial statements and related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q. Overview Google is a global technology leader focused on improving the ways people connect with information. Our innovations in web search and advertising have made our website a top internet property and our brand one of the most recognized in the world. Our mission is to organize the world’s information and make it universally accessible and useful. We serve three primary constituencies:
How We Generate Revenue Advertising revenues made up 96% for the three and six months ended June 30, 2010 and 97% of our revenues for the three and six months ended June 30, 2011. We derive most of our additional revenues from offering display advertising management services to advertisers, ad agencies, and publishers, as well as licensing our enterprise products, search solutions, and web search technology. Google AdWords is our auction-based advertising program that enables advertisers to place text-based and display ads on our websites and our Google Network Members’ websites. Display advertising comprises the videos, text, images, and other interactive ads that run across the web on computers and mobile devices, including smart phones and handheld computers such as netbooks and tablets. Most of our AdWords customers pay us on a cost-per-click basis, which means that an advertiser pays us only when a user clicks on one of its ads. We also offer AdWords on a cost-per-impression basis that enables advertisers to pay us based on the number of times their ads appear on our websites and our Google Network Members’ websites as specified by the advertiser. For advertisers using our AdWords cost-per-click pricing, we recognize as revenue the fees charged to advertisers each time a user clicks on one of the ads that appears next to the search results or content on our websites or our Google Network Members’ websites. For advertisers using our AdWords cost-per-impression pricing, we recognize as revenue the fees charged to advertisers each time their ads are displayed on our websites or our Google Network Members’ websites. Our AdWords agreements are generally terminable at any time by our advertisers. Google AdSense refers to the online programs through which we distribute our advertisers’ AdWords ads for display on the websites of our Google Network Members, as well as programs to deliver ads on television. Our AdSense programs include AdSense for search and AdSense for content. AdSense for search is our online service for distributing relevant ads from our advertisers for display with search results on our Google Network Members’ websites. To use AdSense for search, most of our AdSense for search partners add Google search functionality to their web pages in the form of customizable Google search boxes. When visitors of these websites search either the website or the internet using these customizable search boxes, we display relevant ads on the search results pages, targeted to match user search queries. Ads shown through AdSense for search are text ads.
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Table of ContentsAdSense for content is our online service for distributing ads from our advertisers that are relevant to content on our Google Network Members’ websites. Under this program, we use automated technology to analyze the meaning of the content on the web page and serve relevant ads based on the meaning of such content. For example, a web page on an automotive blog that contains an entry about vintage cars might display ads for vintage car parts or vintage car shows. These ads are displayed in spaces that our AdSense for content partners have set aside on their websites. AdSense for content allows a variety of ad types to be shown, including text ads, image ads, Google Video Ads, link units (which are sets of clickable links to topic pages related to page content), themed units (which are regular text ads with graphic treatments that change seasonally and by geography), and gadget ads (which are customized “mini-sites” that run as ads on AdSense publisher websites). For our online AdSense program, our advertisers pay us a fee each time a user clicks on one of our advertisers’ ads displayed on our Google Network Members’ websites or, for those advertisers who choose our cost-per-impression pricing, as their ads are displayed. To date, we have paid most of these advertiser fees to our Google Network Members, and we expect to continue doing so for the foreseeable future. We recognize these advertiser fees as revenue and the portion of the advertiser fee we pay to our Google Network Members as traffic acquisition costs under cost of revenues. Google Network Members do not pay any fees associated with the use of our AdSense program on their websites. Our agreements with Google Network Members consist largely of uniform online “click-wrap” agreements that members enter into by interacting with our registration websites. The standard agreements have no stated term and are terminable at will. Agreements with our larger members are individually negotiated. Both the standard agreements and the negotiated agreements require us to share with the Google Network Member most of the advertiser fees generated by users clicking on ads on the Google Network Member’s website or, for advertisers who choose our cost-per-impression pricing, as the ads are displayed on the Google Network Member’s website. For example, under our standard agreements, we pay 51% and 68% of the fees collected from advertisers to our Google Network Members in AdSense for search and AdSense for content, respectively. Google ads for televisions enable advertisers, operators, and programmers to buy, schedule, deliver, and measure ads on television. We recognize as revenue the fees charged to advertisers each time an ad is displayed on television in accordance with the related agreements. We also offer display advertising management services such as media planning, buying, implementation, and measurement tools for advertisers and agencies, and forecasting and reporting tools for publishers. We recognize the related fees as other revenues in the period advertising impressions are delivered. In January 2010, we launched, and in July 2010, we discontinued, our direct-to-consumer web store channel of distributing our Nexus One mobile phone. We had recognized fees derived from the sale of these phones as other revenues in the period in which they were delivered. We do not expect to recognize any additional revenue associated with the sale of these phones in the future. We have entered into arrangements with certain content providers under which we distribute or license their video and other content. Our agreements with content providers are typically standard agreements with no stated term and are terminable at will. Agreements with our larger members are individually negotiated. Both the standard agreements and the negotiated agreements require us to pay the content providers for the content we license. In a number of these arrangements, we display ads on the pages of our websites and our Google Network Members’ websites from which the content is viewed and share most of the fees these ads generate with the content providers and Google Network Members. We recognize these advertiser fees as revenue. We recognize the portion of the advertiser fees we pay to our content providers as content acquisition costs under cost of revenues and the portion we pay to our Google Network Members as traffic acquisition costs. We believe the factors that influence the success of our advertising programs include the following:
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Trends in Our Business Advertising transactions continue to shift from offline to online as the digital economy evolves. This has contributed to the rapid growth of our business since inception, resulting in substantially increased revenues, and we expect that our business will continue to grow. However, our revenue growth rate has generally declined over time, and it could do so in the future as a result of a number of factors, including increasing competition, challenges in maintaining our growth rate as our revenues increase to higher levels, and increasing maturity of the online advertising market and other markets in which we participate. In addition, we plan to continue to invest aggressively in our core areas of strategic focus. The main focus of our advertising programs is to provide relevant and useful advertising to our users, reflecting our commitment to constantly improve their overall web experience. As a result, we expect to continue to take steps to improve the relevance of the ads displayed on our websites and our Google Network Members’ websites. These steps include not displaying ads that generate low click-through rates or that send users to irrelevant or otherwise low quality websites and terminating our relationships with those Google Network Members whose websites do not meet our quality requirements. We may also continue to take steps to reduce the number of accidental clicks by our users. These steps could negatively affect the growth rate of our revenues. Both seasonal fluctuations in internet usage and traditional retail seasonality have affected, and are likely to continue to affect, our business. Internet usage generally slows during the summer months, and commercial queries typically increase significantly in the fourth quarter of each year. These seasonal trends have caused, and will likely continue to cause, fluctuations in our quarterly results, including fluctuations in sequential revenues, as well as aggregate paid click and average cost-per-click growth rates. The operating margin we realize on revenues generated from ads placed on our Google Network Members’ websites through our AdSense program is significantly lower than the operating margin we realize from revenues generated from ads placed on our websites because most of the advertiser fees from ads served on Google Network Members’ websites are shared with our Google Network Members. For the past five years, growth in advertising revenues from our websites has generally exceeded that from our Google Network Members’ websites. This trend has had a positive impact on our operating margins, and we expect that this will continue for the foreseeable future, although the relative rate of growth in revenues from our websites compared to the rate of growth in revenues from our Google Network Members’ websites may vary over time. We also continue to invest aggressively in our systems, data centers, corporate facilities, information technology infrastructure, and employees. We expect to increase our hiring in 2011 and provide competitive compensation programs for our employees. For instance, effective January 1, 2011, we increased base salaries for all of our non-executive employees by 10% and shifted a portion of the bonus into base salary. Our full-time employee headcount was 21,805 at June 30, 2010 and 28,768 at June 30, 2011. Acquisitions will also remain an important component of our strategy and use of capital, and we expect our current pace of acquisitions to continue. We expect our cost of revenues will increase in dollars and may increase as a percentage of revenues in future periods, primarily as a result of forecasted increases in traffic acquisition costs, data center costs, credit card and other transaction fees, content acquisition costs, and other costs. In particular, traffic acquisition costs as a percentage of advertising revenues may increase in the future if we are unable to continue to improve the monetization or generation of revenues from traffic on our websites and our Google Network Members’ websites. As we expand our advertising programs and other products to international markets, we continue to increase our exposure to fluctuations in foreign currency to U.S. dollar exchange rates. We have a foreign exchange risk management program that is designed to reduce our exposure to fluctuations in foreign currency exchange rates. However, this program will not fully offset the effect of fluctuations on our revenues and earnings.
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Table of ContentsResults of Operations The following table presents our historical operating results as a percentage of our revenues for the periods indicated:
Revenues The following table presents our revenues, by revenue source, for the periods presented (in millions):
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Table of ContentsThe following table presents our revenues, by revenue source, as a percentage of total revenues for the periods presented:
The increase in our revenues from the three and six months ended June 30, 2010 to the three and six months ended June 30, 2011 resulted primarily from an increase in advertising revenues generated by Google websites and Google Network Members’ websites. The increase in advertising revenue for Google websites and Google Network Members’ websites from the three and six months ended June 30, 2010 to the three and six months ended June 30, 2011 resulted primarily from an increase in the number of paid clicks through our advertising programs and, to a lesser extent, an increase in the average cost-per-click paid by our advertisers. The increase in the number of paid clicks generated through our advertising programs was due to an increase in aggregate traffic, certain monetization improvements including new ad formats, and the continued global expansion of our products, and our advertiser and user base, as well as an increase in the number of Google Network Members. The increase in the average cost-per-click paid by our advertisers was primarily driven by the increased spending from advertisers and a general weakening of the U.S dollar compared to foreign currencies (primarily the Euro and the British pound). In addition, the increase in advertising revenue for Google Network Members’ websites from the three and six months ended June 30, 2010 to the three and six months ended June 30, 2011 was partially offset by the loss of a search partnership, and to a lesser extent by a search quality improvement made during the first half of 2011. Improvements in our ability to ultimately monetize increased traffic primarily relate to enhancing the end user experience, including providing end users with ads that are more relevant to their search queries or to the content on the Google Network Members’ websites they visit. For instance, these improvements include moving a portion of the first line of the ad to the heading to better promote the content of the ad, providing an option to preview the ad, and moving the ad’s URL (uniform resource locator) to a separate line below the heading for greater page format consistency. Aggregate paid clicks on Google websites and Google Network Members’ websites increased approximately 18% from the three and six months ended June 30, 2010 to the three and six months ended June 30, 2011. Average cost-per-click on Google websites and Google Network Members’ websites increased approximately 12% from the three months ended June 30, 2010 to the three months ended June 30, 2011 and 10% from the six months ended June 30, 2010 to the six months ended June 30, 2011. The rate of change in aggregate paid clicks and average cost-per-click, and their correlation with the rate of change in revenues, has fluctuated and may fluctuate in the future because of various factors, including the revenue growth rates on our websites compared to those of our Google Network Members, advertiser competition for keywords, changes in foreign currency exchange rates, seasonality, the fees advertisers are willing to pay based on how they manage their advertising costs, and general economic conditions. In addition, traffic growth in emerging markets compared to more mature markets and across various advertising verticals also contributes to these fluctuations. Changes in aggregate paid clicks and average cost-per-click may not be indicative of our performance or advertiser experiences in any specific geographic market, vertical, or industry.
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Table of ContentsWe believe that the increase in the number of paid clicks on Google websites and Google Network Members’ websites is substantially the result of our commitment to improving the relevance and quality of both our search results and the advertisements displayed, which we believe results in a better user experience, which in turn results in more searches, advertisers, and Google Network Members and other partners. Revenues by Geography The following table presents our domestic and international revenues as a percentage of consolidated revenues, determined based on the billing addresses of our customers:
The growth in international revenues (other than the United Kingdom) as a percentage of consolidated revenues from the three and six months ended June 30, 2010 to the three and six months ended June 30, 2011 resulted largely from increased acceptance of our advertising programs and our continued progress in developing localized versions of our products for these international markets and, to a lesser extent, a general weakening of the U.S dollar compared to foreign currencies (primarily the Euro and the Japanese yen). The general weakening of the U.S. dollar relative to certain foreign currencies (primarily the Euro, British pound, and Japanese yen) from the three months ended June 30, 2010 to the three months ended June 30, 2011 had a favorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $81 million, or 8%, lower and our revenues from the rest of the world would have been approximately $336 million, or 9%, lower in the three months ended June 30, 2011. This is before consideration of hedging gains of $19 million and $60 million recognized to revenues from the United Kingdom and the rest of the world in the three months ended June 30, 2010 and hedging gains of $4 million recognized to revenues from the rest of the world in the three months ended June 30, 2011. The general weakening of the U.S. dollar relative to certain foreign currencies (primarily the Euro, British pound, and Japanese yen) from the six months ended June 30, 2010 to the six months ended June 30, 2011 had a favorable impact on our international revenues. Had foreign exchange rates remained constant in these periods, our revenues from the United Kingdom would have been $102 million, or 5%, lower and our revenues from the rest of the world would have been approximately $342 million, or 5%, lower and in the six months ended June 30, 2011. This is before consideration of hedging gains of $29 million and $60 million recognized to revenues from the United Kingdom and the rest of the world in the six months ended June 30, 2010 and hedging gains of $4 million and $14 million recognized to revenues from the United Kingdom and the rest of the world in the six months ended June 30, 2011. The aforementioned foreign exchange impact on international revenues is calculated by translating current quarter revenues using prior quarter and prior year exchange rates, as well as excluding any hedging gains realized in the current periods. We consider this information useful as it facilitates a comparison to our historical revenue performance on a constant currency basis. Although we expect to continue to make investments in international markets, these investments may not result in an increase in our international revenues as a percentage of total revenues in 2011 or thereafter. See Note 15 of Notes to Consolidated Financial Statements included in Part I, Item 1 of this Quarterly Report on Form 10-Q for additional information about geographic areas. Costs and Expenses Cost of Revenues Cost of revenues consists primarily of traffic acquisition costs. Traffic acquisition costs consist of amounts ultimately paid to our Google Network Members under AdSense arrangements and to certain other partners (our distribution partners) who distribute our toolbar and other products (collectively referred to as access points) or otherwise direct search queries to our website (collectively referred to as distribution arrangements). These amounts are primarily based on the revenue share arrangements with our Google Network Members and distribution partners.
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Table of ContentsCertain distribution arrangements require us to pay our distribution partners based on a fee per access point delivered and not exclusively—or at all—based on revenue share. The fees are non-refundable. Further, these distribution arrangements are terminable at will, although under the terms of certain contracts, we or our distribution partners may be subject to penalties in the event of early termination. We recognize fees under these distribution arrangements over the estimated useful lives of the access points (approximately two years) to the extent we can reasonably estimate those lives and they are longer than one year, or based on any contractual revenue share, if greater. Otherwise, we expense the fees as incurred. The estimated useful life of the access points is based on the historical average period of time they generate traffic and revenues. Cost of revenues also includes the expenses associated with the operation of our data centers, including depreciation, labor, energy and bandwidth costs, content acquisition costs, amortization of acquired intangible assets, and credit card and other transaction fees related to processing customer transactions. We have entered into arrangements with certain content providers under which we distribute or license their video and other content. In a number of these arrangements we display ads on the pages of our websites and our Google Network Members’ websites from which the content is viewed and share most of the fees these ads generate with the content providers and the Google Network Members. The following table presents our cost of revenues and cost of revenues as a percentage of revenues, and our traffic acquisition costs and traffic acquisition costs as a percentage of advertising revenues, for the periods presented (dollars in millions):
Cost of revenues increased $705 million from the three months ended June 30, 2010 to the three months ended June 30, 2011. The increase was primarily related to an increase in traffic acquisition costs of $292 million resulting from more advertiser fees generated through our AdSense program. The increase was also related to an increase in traffic acquisition costs of $86 million from our distribution arrangements as a result of more traffic directed to our websites, as well as more distribution fees paid. The decrease in traffic acquisition costs as a percentage of advertising revenues was primarily due to an increase in the proportion of advertising revenues from our websites compared to our Google Network Members’ websites, and more revenues realized from Google Network Members to whom we pay less revenue share. In addition, there was an increase in data center costs of $204 million primarily resulting from the depreciation of additional information technology assets and data center buildings and an increase in labor, energy, and bandwidth costs, and an increase in content acquisition costs of $59 million primarily related to content displayed on YouTube. Cost of revenues increased $1,188 million from the six months ended June 30, 2010 to the six months ended June 30, 2011. The increase was primarily related to an increase in traffic acquisition costs of $549 million resulting from more advertiser fees generated through our AdSense program. The increase was also related to an increase in traffic acquisition costs of $156 million from our distribution arrangements as a result of more traffic directed to our websites, as well as more distribution fees paid. The decrease in traffic acquisition costs as a percentage of advertising revenues was primarily due to an increase in the proportion of advertising revenues from our websites compared to our Google Network Members’ websites, more revenues realized from Google Network Members to whom we pay less revenue share, and, to a lesser extent, expiration of an AdSense arrangement under which we paid guaranteed minimum revenue share. In addition, there was an increase in data center costs of $283 million primarily resulting from the depreciation of additional information technology assets and data center buildings and an increase in labor, energy, and bandwidth costs, and an increase in content acquisition costs of $123 million primarily related to content displayed on YouTube, partially offset by a decrease in mobile phone costs.
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Table of ContentsWe expect cost of revenues will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2011 and in future periods, primarily as a result of forecasted increases in traffic acquisition costs, data center costs, credit card and other transaction fees, content acquisition costs, and other costs. Traffic acquisition costs as a percentage of advertising revenues may fluctuate in the future based on a number of factors, including the following:
Research and Development The following table presents our research and development expenses, and research and development expenses as a percentage of revenues, for the periods presented (dollars in millions):
Research and development expenses consist primarily of compensation and related costs for personnel responsible for the research and development of new and existing products and services. We expense research and development costs as they are incurred. Research and development expenses increased $336 million from the three months ended June 30, 2010 to the three months ended June 30, 2011. This increase was primarily due to an increase in labor and facilities related costs of $209 million primarily as a result of a 30% increase in research and development headcount, including headcount from acquisitions, as well as a 10% increase in base salaries of non-executive employees effective January 1, 2011. In addition, there was an increase in stock-based compensation expense of $45 million. Research and development expenses increased $740 million from the six months ended June 30, 2010 to the six months ended June 30, 2011. This increase was primarily due to an increase in labor and facilities related costs of $499 million primarily as a result of a 30% increase in research and development headcount, including headcount from acquisitions, as well as a 10% increase in base salaries of non-executive employees effective January 1, 2011. In addition, there was an increase in stock-based compensation expense of $91 million. We expect that research and development expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2011 and future periods because we expect to continue to invest in building the necessary employee and systems infrastructures required to support the development of new, and improve existing, products and services. Sales and Marketing The following table presents our sales and marketing expenses, and sales and marketing expenses as a percentage of revenues, for the periods presented (dollars in millions):
Sales and marketing expenses consist primarily of compensation and related costs for personnel engaged in customer service, sales, and sales support functions, as well as advertising and promotional expenditures.
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Table of ContentsSales and marketing expenses increased $462 million from the three months ended June 30, 2010 to the three months ended June 30, 2011. This increase was primarily due to an increase in labor and facilities related costs of $201 million primarily due to a 30% increase in sales and marketing headcount, as well as a 10% increase in base salaries of non-executive employees effective January 1, 2011. In addition, there was an increase in advertising and promotional expenses of $185 million. Sales and marketing expenses increased $881 million from the six months ended June 30, 2010 to the six months ended June 30, 2011. The increase was primarily related to an increase in labor and facilities related costs of $380 million primarily due to a 30% increase in sales and marketing headcount, as well as a 10% increase in base salaries of non-executive employees effective January 1, 2011. In addition, there was an increase in advertising and promotional expenses of $368 million. We expect that sales and marketing expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2011 and future periods, as we expand our business globally, increase advertising and promotional expenditures in connection with new and existing products, and increase the level of service we provide to our advertisers, Google Network Members, and other partners. General and Administrative The following table presents our general and administrative expenses, and general and administrative expenses as a percentage of revenues, for the periods presented (dollars in millions):
General and administrative expenses consist primarily of compensation and related costs for personnel and facilities, and include costs related to our facilities, finance, human resources, information technology, and legal organizations, and fees for professional services. Professional services are principally comprised of outside legal, audit, information technology consulting, and outsourcing services. General and administrative expenses increased $187 million from the three months ended June 30, 2010 to the three months ended June 30, 2011. This increase was primarily due to an increase in labor and facilities related costs of $119 million primarily as a result of a 33% increase in general and administrative headcount and a 10% increase in base salaries of non-executive employees effective January 1, 2011, as well as an increase in professional services of $17 million, the majority of which related to legal costs and consulting services. In addition, there was an increase in stock-based compensation expense of $20 million. General and administrative expenses increased $373 million from the six months ended June 30, 2010 to the six months ended June 30, 2011. This increase was primarily due to an increase in labor and facilities related costs of $191 million primarily as a result of a 33% increase in general and administrative headcount and a 10% increase in base salaries of non-executive employees effective January 1, 2011, as well as an increase in professional services of $74 million, the majority of which related to legal costs and consulting services. In addition, there was an increase in stock-based compensation expense of $47 million. As we expand our business and incur additional expenses, we expect general and administrative expenses will increase in dollar amount and may increase as a percentage of revenues in the remainder of 2011 and future periods. Charge Related to Potential Resolution of Department of Justice Investigation In May 2011, in connection with a potential resolution of an investigation by the United States Department of Justice into the use of Google advertising by certain advertisers, we accrued $500 million for the three month period ended March 31, 2011. Although we cannot predict the final outcome of this matter, we believe that any liability in excess of the amount accrued will not have a material adverse effect on our business, consolidated financial position, results of operations, or cash flows.
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Table of ContentsStock-Based Compensation The following table presents our stock-based compensation, and stock-based compensation as a percentage of revenues, for the periods presented (dollars in millions):
Stock-based compensation increased $126 million and $266 million from the three and six months ended June 30, 2010 to the three and six months ended June 30, 2011. These increases were primarily due to additional stock awards issued to existing and new employees. We estimate stock-based compensation to be approximately $1.9 billion in 2011 and $3.8 billion thereafter. This estimate does not include expenses to be recognized related to employee stock awards that are granted after June 30, 2011 or non-employee stock awards that have been or may be granted. In addition, to the extent forfeiture rates are different from what we have anticipated, stock-based compensation related to these awards will be different from our expectations. Interest and Other Income, Net Interest and other income, net increased $135 million from the three months ended June 30, 2010 to the three months ended June 30, 2011. This increase was primarily driven by an increase in interest income of $76 million due to an increase in our cash and investment balances and higher yields, a decrease in net foreign exchange related costs of $34 million, and an increase in realized gains on sale of marketable securities of $32 million. Interest and other income, net increased $213 million from the six months ended June 30, 2010 to the six months ended June 30, 2011. This increase was primarily driven by an increase in interest income of $170 million due to an increase in our cash and investment balances and higher yields, an increase in realized gains on sale of marketable securities of $34 million and a decrease in net foreign exchange related costs of $11 million. The costs of our foreign exchange hedging activities that we recognized to interest and other income, net are primarily a function of the notional amount of the option and forward contracts and their related duration, and the movement of the foreign exchange rates relative to the strike prices of the contracts, as well as the volatility of the foreign exchange rates. As we expand our international business, we believe costs related to hedging activities under our foreign exchange risk management program may increase in dollar amount in the remainder of 2011 and future periods. Provision for Income Taxes The following table presents our provision for income taxes, and effective tax rate for the periods presented (dollars in millions):
Our provision for income taxes decreased from the three months ended June 30, 2010 to the three months ended June 30, 2011, primarily as a result of proportionately more earnings expected to be realized in countries where we have lower statutory tax rates, partially offset by an increase in federal income taxes, driven by higher taxable income year over year. Our effective tax rate decreased from the three months ended June 30, 2010 to the three months ended June 30, 2011, primarily as a result of proportionately more earnings expected to be realized in countries where we have lower statutory tax rates. The decrease is also attributable to a decrease in state income taxes and higher research and development credit recognized in the three months ended June 30, 2011.
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Table of ContentsOur provision for income taxes increased from the six months ended June 30, 2010 to the six months ended June 30, 2011, primarily as a result of an increase in federal income taxes, driven by higher taxable income year over year, partially offset by proportionately more earnings expected to be realized in countries where we have lower statutory tax rates. Our effective tax rate decreased from the six months ended June 30, 2010 to the six months ended June 30, 2011, primarily as a result of proportionately more earnings expected to be realized in countries where we have lower statutory tax rates and a decrease in state income taxes and higher research and development credit recognized in the six months ended June 30, 2011, partially offset by a recognition of charge related to a potential resolution of an investigation by the Department of Justice which is not deductible for tax purposes. Our effective tax rate could fluctuate significantly on a quarterly basis and could be adversely affected to the extent earnings are lower than anticipated in countries where we have lower statutory rates and higher than anticipated in countries where we have higher statutory rates. Our effective tax rate could also fluctuate due to the net gains and losses recognized by legal entities on certain hedges and related hedged intercompany and other transactions under our foreign exchange risk management program, by changes in the valuation of our deferred tax assets or liabilities, or by changes in tax laws, regulations, or accounting principles, as well as certain discrete items. In addition, we are subject to the continuous examination of our income tax returns by the IRS and other tax authorities. We regularly assess the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of our provision for income taxes. Liquidity and Capital Resources In summary, our cash flows were as follows (in millions):
At June 30, 2011, we had $39.1 billion of cash, cash equivalents, and marketable securities. Cash equivalents and marketable securities are comprised of highly liquid debt instruments of the U.S. government and its agencies, municipalities in the U.S., debt instruments issued by foreign governments, time deposits, money market and other funds, including cash collateral received related to our securities lending program, mortgage-backed securities, and corporate securities. As of June 30, 2011, $18.8 billion of the $39.1 billion of cash, cash equivalents, and marketable securities was held by our foreign subsidiaries. If these funds are needed for our operations in the U.S., we would be required to accrue and pay U.S. taxes to repatriate these funds. However, our intent is to permanently reinvest these funds outside of the U.S. and our current plans do not demonstrate a need to repatriate them to fund our U.S. operations. Our principal sources of liquidity are our cash, cash equivalents, and marketable securities, as well as the cash flow that we generate from our operations. At December 31, 2010 and June 30, 2011, we had unused letters of credit for approximately $65 million and $48 million. We believe that our sources of funding will be sufficient to satisfy our currently anticipated cash requirements through at least the next 12 months. Our liquidity could be negatively affected by a decrease in demand for our products and services. In addition, we may make acquisitions or license products and technologies complementary to our business and may need to raise additional capital through future debt or equity financing to provide for greater flexibility to fund any such acquisitions and licensing activities. Additional financing may not be available at all or on terms favorable to us. We have established a debt financing program of up to $3.0 billion through the issuance of commercial paper. Net proceeds from the commercial paper program are used for general corporate purposes. As of June 30, 2011, we had $749 million of commercial paper outstanding recorded as short-term debt, with a weighted-average interest rate of 0.4% that matures at various dates through November 2011. Average commercial paper borrowings during the quarter were $1.8 billion, and the maximum amount of commercial paper borrowings outstanding during the quarter was $2.7 billion. In conjunction with this program, we established a $3.0 billion revolving credit facility expiring on June 30, 2013. The interest rate for the credit facility is determined based on a formula using certain market rates. As of June 30, 2011, we were in compliance with the financial covenant in the credit facility. No amounts were outstanding under the credit facility as of June 30, 2011. Additionally, as of June 30, 2011, we had $468 million outstanding under a secured promissory note with an interest rate of 1.0% that matures in December 2011. Proceeds of this note were used for the acquisition of an office building in New York City.
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Table of ContentsIn May 2011, we issued $3.0 billion of unsecured senior notes in three equal tranches, due in 2014, 2016, and 2021. The stated interest rates of the notes due in 2014, 2016, and 2021 are 1.25%, 2.125%, and 3.625%, respectively. The net proceeds from the sale of the notes were used to repay a portion of our outstanding commercial paper and for general corporate purposes. As of June 30, 2011, the total carrying value and estimated fair value of our long-term debt were $3.0 billion. The estimated fair value is based on quoted prices for our publicly-traded debt as of June 30, 2011. We are not subject to any financial covenants under the notes. Cash provided by operating activities in the six months ended June 30, 2011 was $6,691 million and consisted of net income of $4,304 million, adjustments for non-cash items of $2,208 million, and cash provided by working capital and other activities of $179 million. Adjustments for non-cash items primarily consisted of $866 million of stock-based compensation expense, $648 million of depreciation and amortization expense on property and equipment, $464 million of deferred income taxes, and $208 million of amortization of intangible and other assets. In addition, the increase in cash from changes in working capital activities primarily consisted of an increase in accrued expenses and other liabilities of $297 million primarily due to a charge recorded related to a potential resolution of an investigation by the Department of Justice, an increase in accounts payable of $77 million primarily a result of the growth of our business, and an increase in deferred revenue of $69 million. These increases were partially offset by an increase in prepaid revenue share, expenses and other assets of $148 million and a net decrease in income taxes payable and deferred income taxes of $98 million. The decrease in income taxes payable and deferred income taxes reflected primarily increased estimated income taxes paid during the second quarter of 2011 with respect to the year ending December 31 2011, partially offset by additional tax obligations accrued. Cash provided by operating activities in the six months ended June 30, 2010 was $4,669 million and consisted of net income of $3,795 million, adjustments for non-cash items of $1,240 million and cash used in working capital and other activities of $366 million. Adjustments for non-cash items primarily consisted of $600 million of stock-based compensation expense, $530 million of depreciation and amortization expense on property and equipment, and $143 million of amortization of intangible and other assets, partially offset by $31 million of excess tax benefits from stock-based award activities. In addition, the decrease in cash from changes in working capital activities primarily consisted of an increase of $197 million in accounts receivable | |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||