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Google and Yahoo!: Rolling In It

Google and Yahoo! have been raking in the cash for years, as large advertisers shift more spending to online media. But judging by recent earnings figures from the Internet leaders, the trend is just hitting its stride.

The companies blew past third-quarter expectations this week, bucking what's typically a preholiday slump in online-ad spending, in large part due to aggressive ad-buying by mammoth marketers. Google's stock (GOOG) jumped 10%, to $330, in extended trading on Oct. 20, after the company posted $381 million in net income -- a 51% hike after accounting for a large, one-time settlement fee paid in the year-earlier period. And Yahoo's stock (YHOO) has climbed 5%, to $35.26, since its Oct. 18 numbers beat analysts' top- and bottom-line estimates.

Driving this breakneck growth is the companies' ability to draw advertising dollars onto the Internet -- and away from other media. In 2002, 2.5% of U.S. ad dollars were spent online. The figure is expected to reach 4.6% this year and 7.5% by 2009, according to researcher eMarketer. Leading the way have been companies such as McDonald's (MCD), General Mills (GIS), and DreamWorks.

MERGING BRANCHES. Google and Yahoo have put themselves in prime position to capitalize on the trend, accounting for about half of these online dollars in the U.S., according to eMarketer Senior Analyst David Hallerman. "It's a big sea change," Jonathan Rosenberg, Google's vice-president of product management, said on a conference call with analysts. "There will be significantly more money transitioning into the pay-per-click model."

A key driver for Yahoo has been the increasing overlap between two kinds of online advertising -- so-called branded ads and advertising associated with Web searches. Unlike Google, Yahoo does brisk business selling branded ads, image-based units that adorn many of its Web pages. The ads have long been appealing to many traditional businesses, such as entertainment companies or makers of consumer packaged goods, which use the marketing to build their brands online as well as drive traffic to their own sites.

Research shows that consumers often check out products online before making a purchase offline. That's luring big advertisers to search-related ads as well. Yahoo has seen a surge in search-ad spending among automobile makers, financial-services companies, and traditional retailers, among others.

SEARCH-CENTRIC. "We're seeing an increasing overlap between the clients of sponsor search and brand marketing," Yahoo Chief Financial Officer Sue Decker told analysts on a conference call.

For its part, Google relies mainly on search marketing. Earlier this year, the company began selling image-based ads to be placed on the sites of its publishing partners, rather than the famously Spartan (see BW Online, 10/03/05, "Google's Search for Simplicity"). But analysts say the branded-ad business has been negligible for Google.

Google's affinity for search-related ads hasn't cost it large advertisers. The company earlier this year said it does business with about one-quarter of the world's largest 1,000 advertisers. The company hasn't updated that number, but insists it's winning more of these businesses. During its quarterly conference call, for instance, Google execs highlighted a relationship with Paramount Pictures, which they say has been using multiple Google products to promote films such as Hustle & Flow. "We're attracting a lot more interest from Fortune 500 companies," Google CEO Eric Schmidt said on the call.

"DIFFICULT WORK." What's more, Google has dramatically improved the effectiveness of its search ads. In the past year, the percentage of Google searchers that click on a paid ad has climbed to 20%, from 15%, according to financial analysts and data from researcher comScore Media Metrix. Even before factoring in the growing number of searches and the rising price of keywords, that jump would represent a 33% increase in sales for Google.

Getting more click mileage from search ads is no automatic slam-dunk. Yahoo, by comparison, generates ad clicks on about 12% of its searches, according to the analysts, though the company has vowed to improve on this figure. To do so, Yahoo has to find the precise formula for displaying the most relevant ads, while also tinkering with the look of the search-results pages. "This is very difficult work," says Mark Mahaney, analyst at Citigroup (C).

And even though Google and Yahoo are well positioned to keep riding the online advertising wave, they will be challenged to keep dazzling starry-eyed investors. Google's stock has soared more than threefold since its initial public offering 14 months ago, giving it a market value of $85 billion. Yahoo, meanwhile, trades at 48-times its estimated 2006 earnings, more than Google, eBay (EBAY), or Amazon.

TIPPING POINT. With both companies priced to near perfection, even a minor slip could send investors scurrying. Witness the 5% drop in Google's shares in extended trading on July 21, after shareholders were unimpressed by a more than fourfold surge in second-quarter profit (see BW Online, 07/22/05, "Google Proves It's Mortal").

Yet for now, with a rising number of big companies plunging into online advertising at a rapid clip, few shareholders are straying far.


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