Google: Just Not Good Enough

Disappointing fourth-quarter results are likely to usher in an era of closer scrutiny of the search titan's revenue sources

Quarter after quarter, Google has consistently quashed the doubts. Concerned about slowing growth in Internet search? Too much revenue from a single source? Difficulty launching new businesses? Results from the Web-search kingpin have rendered such questions moot, surpassing Wall Street financial projections with ease and propelling Google's stock northward to a staggering $433.

Until now. Google's fourth-quarter earnings, uncorked on Jan. 31, greeted investors like a bottle of flat champagne. With the market expecting yet another breakthrough performance, Google notched $1.29 billion in sales, the midpoint of analysts' estimates.

Worse, a higher-than-expected tax rate translated to a smaller-than-projected gain in profit. Net income rose only 82%, to $372 million.


  For many companies, results like that are the stuff of dreams. Not Google. Its shares tumbled 12%, to $381.10, in extended trading. The fallout continued the following day, with Google's shares dropping 8.6%, to $395.28, in afternoon trading.

What's the lesson in all this? Google, it appears, is reentering the stratosphere. And mundane business concerns, such as revenue diversity or Google's ability to keep outpacing the search market, are likely to come under closer scrutiny.

The new level of skepticism has been led by a couple of rogue analysts. In January, as some analysts ratcheted up Google price targets as high as $600, two firms -- Stifel Nicolaus and Standard & Poor's (owned by The McGraw-Hill Companies, publisher of BusinessWeek) -- dropped their Google ratings to sell. Following the fourth-quarter letdown, such a tough-minded perspective will strike many as being on the mark.

Consider the issue of revenue diversity. With Google deriving some 99% of sales from simple text-based ads, placed alongside search results and other Internet pages, it would seem exposed to a market slowdown. Indeed, this issue has nagged at some analysts and observers for much of Google's rocket-ship ride (see BW, "Google: A $50 Billion One-Trick Pony?").


  But to now, the concern has come across as unfounded. Growth in the U.S. search market, for instance, was slated to slow to 40% in 2005, according to researcher eMarketer. Google, which generates the majority of its revenues from the US, notched 92% growth in 2005 sales -- even with its underwhelming fourth quarter.

Google has used some daunting feats to blow past the rest of the field. First, it has staved off competitors' efforts to gobble up market share. Google had as much as 63% of global searches through November, according to Majestic Research. Second, Google has boosted the effectiveness of its search ads, which now get clicked on at least 33% more frequently than they did even a year ago.

Both of these accomplishments put Google in a greater position to benefit from an ongoing surge in the price companies pay to advertise next to search keywords.


  But can the gains be repeated? Recent increases in the frequency of clicks on Google ads were fueled in part by the addition of a third advertising link at the top of some results pages. Google can't tinker much more without sacrificing its trademark Spartan user interface.

Moreover, Google's ability to gain market share from determined and deep-pocketed competitors, Yahoo (YHOO) and Microsoft (MSFT), has bested even its supporters' wildest expectations. At some point these share gains will also level off, and perhaps even begin to shrink.

Then there's the pesky matter of pricing. Some analysts are beginning to question how much growth remains in keyword prices. Martin Pyykkonen, an analyst at Hoefer & Arnett, estimates that rising keyword prices have contributed to about one-third of Google's growth over the past year.


  But major keyword buyers, such as eBay (EBAY), are beginning to grouse about the rising cost of acquiring customers through search. So there could be some leveling off here as well. Giving credence to such concerns, search advertising firm Fathom Online saw the average price of its keyword index drop 16% in the fourth quarter.

Google, meanwhile, has no easy path to diversifying its business. It has begun to make a number of large bets. Earlier this month, Google acquired radio advertising firm dMarc Broadcasting for a sum that could reach $1.2 billion. Also in January, Google unveiled a video store, where shows and sports events are sold for a few dollars apiece. And late in 2005, Google rolled out Google Base, which someday could emerge as a platform for classified advertising.

All of these represent interesting bets that would expand Google's business into new terrain. But for Google to even generate 20% of its sales from nonsearch businesses by 2007, the company would need to develop as much as $1.5 billion in alternative revenue streams by that time. That's a tall order for the company's roster of fledgling businesses. "I'm still looking and hoping to see signs of revenue diversity," says Pyykkonen.


  Still, some Google bulls remain undaunted by the company's fourth-quarter performance. Had the tax rate come in at the expected 30%, Google's profits would have met analyst expectations.

Furthermore, with more companies moving their advertising budgets to the Internet, Google will be well positioned to benefit. And its penetration of budding international markets far exceeds that of chief rivals, Yahoo and Microsoft. "There is no operational, execution, or strategic issue that they missed," says Safa Rashtchy, analyst at Piper Jaffray.

That may be the case. But with skeptics emboldened by the miss, a new era of Google scrutiny may be dawning.

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