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Google R&D Pays Dividends

Two days after Yahoo! (YHOO) stunned Wall Street with disappointing second-quarter results, leading to a 21% plunge in its stock price, chief rival Google (GOOG) on Thursday assuaged investors with its own financial results. The key difference: While Yahoo pushed back the timetable for its new-and-improved search-advertising system well into 2007, Google continues to enhance the way it selects and displays ads "every day, every quarter," according to Chief Financial Officer George Reyes.

Such efforts to improve the quality of its search ads are a core piece of Google's booming investment in research and development. The search giant is expected to spend about $1.2 billion on R&D this year, a staggering 148% increase over last year. And while Google's new product initiatives span everything from online spreadsheets to a new payment system, roughly 70% of its R&D efforts go into improving its core search offering and the advertising that adorns it.

WINNING FORMULA. The results have been bountiful. Because Google is able to better match ads to a user's search query, analysts have estimated that Google searchers are roughly 33% more likely to click on an ad than someone using Yahoo. Couple that with Google's gains in search market share—it now handles nearly two-thirds of the world's queries—and you've got a winning formula. For the second quarter, this translated into 88% growth in net sales, to $1.7 billion, while net profits jumped 110%, to $721 million. Yahoo's net revenues rose 32%, to $1.1 billion, and its net profits increased 8%, to $164 million, not counting exceptional gains on the sale of stock in the year-earlier period.

Still, although Google's forays in search and advertising have been wildly successful, its efforts to crack new businesses have yet to generate major breakthroughs (see, 7/10/06, "So Much Fanfare, So Few Hits"). Little evidence surfaced during the second-quarter results to show progress in that direction. Nearly 90% of visitors to Google's sites use it only to search for content and images on the Internet. And 99% of its revenues continue to come from the small, text-based ads that adorn its search results pages and the pages of partner Web sites.

DIVERSITY NEEDED. Such reliance on a single revenue stream worries some observers. Search advertising is expected to grow a robust 30% to 40% in the next couple of years, but Google's own revenue growth will decelerate unless it can more than double the market's breakneck clip by garnering more market share, squeezing out more money for each search, and increasing the number of partners who carry their ads. "Google needs to profitably diversify its revenue base," wrote Martin Pyykkonen, analyst at Global Crown Capital Equity Research, in a report issued last month.

One of Google's major bets appears to be on its recently launched payment platform, dubbed Google Checkout. Launched in June, the payment system will rival that of eBay's (EBAY) PayPal. (see, 6/29/06, "Google to Unveil Online Payment Service"). Google's avowed goals are to make it simpler to make online payments and to strengthen its ties to merchants who sell on the Web.

But it also presents an interesting opportunity for an alternative revenue stream. PayPal handled more than $27 billion in transactions last year, generating more than $1 billion in revenues for eBay along the way. A new billion-dollar business would represent about 10% of the $10 billion in net revenues that analysts slate for Google in 2007, just the kind of diversity that many hope it can achieve.

NO NEW WINNERS. But cracking this and many other new markets will be difficult. Although Google has developed competitive offerings in maps and news, its offerings in areas such as blog search, instant messaging, and social networking have struggled mightily. "Plenty of interesting things are coming out of Google, but they're just not getting any traction," says Bill Tancer, general manager of research at business-intelligence firm Hitwise.

Google should have plenty of time to work on its flaws. Its dominating lead in search looks unassailable right now, particularly as No. 2 Yahoo struggles. Three months ago, Yahoo execs outlined the timetable for its massive internal project, dubbed "Panama," saying it would roll out gradually over the next several quarters. Now, the company says it may not be fully functional until early 2007.

Meanwhile, the volume of U.S. search queries handled by Google jumped 55% over the past year, according to comScore Media Metrix. Yahoo's search queries rose 21%, and those handled by MSN, owned by Microsoft (MSFT), grew only 8%. Both rivals fell short of the overall market growth of 30%. "The opportunities before us are really unlimited at this point," remarked Google CEO Eric Schmidt on a conference call with Wall Street analysts.

That may be a little too sanguine. But with Google's search business firing on all cylinders, its weaknesses won't likely trip up the company anytime soon.

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