Google's Fourth Quarter: Victim of Its Own Success?

Rob Hof

The search giant blows away earnings, but investors knock the stock down 2% in after-hours trading. Maybe they're disappointed the revenues came in only a little above analysts' estimates? Here are the quarter's results and the slides, but more to come later....

Update: Nice summary of the call by subject at Google Watch.

Update 2: My draft of a story to appear later on BWOnline, after the jump....

Update 3: A detailed and fun analysis at GotAds?. I also noticed Eric Schmidt's liberal use of the word "very," but I like this translation:

Eric Schmidt Says: Really He Means:
Good: Not so hot.
Very good: OK.
Very, very good: Good.
Very, very, very good: Pretty good.

Are Google investors getting spoiled? Even though Google Inc. managed to blow away fourth-quarter earnings on Jan. 31, its shares fell by about 1% in extended trading. But those sellers may have missed the real import of the search giant’s report: More than ever, it’s got the entire advertising world in its sights. And this year, it’s clear that it will come out with guns blazing.

Investors, who had bid up the stock 1.5% before the report, may have hoped for a little stronger revenue growth vs. the third quarter than the 20% Google reported. “Expectations got ahead of themselves,” says Scott W. Devitt, an analyst with Stifel, Nicolaus & Co. But mostly, investors decided to take profits following a 10% rise in the stock so far this year.

And Google had profits to spare. It earned $1.03 billion, nearly triple a year ago, on a 67% jump in revenues, to $3.2 billion. It was the ninth of 10 quarters as a public company that Google, which now accounts for about a quarter of all online advertising, has outperformed expectations.

The big drivers this quarter: strong growth in traffic thanks to holiday shopping and more improvement in the rate at which people click on Google ads. In fact, Chief Executive Eric Schmidt said Google is showing fewer ads per search on average but is making more money because it’s more carefully targeting ads to the most commercial sites. "The targeting and the technical work that we are doing is producing better return for advertisers, better revenue for us, with even fewer advertisements,” he told analysts during a conference call.

Perhaps most interesting for Google’s future, it’s now apparent that advertisers are viewing search—and Google—in a new light. Up to this point, search ads have been almost solely considered a direct-response medium, in which advertisers can measure by the number of clicks and subsequent purchases or other activity how many people they reached.

Now, are starting to use search ads as a branding opportunity just like more traditional ads. “Our advertisers are now placing more brand advertising,” Sergey Brin, cofounder and president of technology, said in the analyst call. And it appears to be working, says John Aiken, managing director at Majestic Research. “They’re benefiting from people searching online and purchasing offline,” he says.

The trend by brick-and-mortar retailers and even consumer packaged goods giants to use Google search ads for branding has made search ads more expensive for small advertisers. But it’s a boon for Google. And ad agencies confirm that it’s starting to take off. “Search can be a very good branding tool,” says Jason Schulman, chief revenue officer for X+1, which helps companies refine their online marketing.

Indeed, Google executives signaled in the clearest way yet their expansive intentions: The company aims to offer a “complete sales and marketing platform for all advertisers,” Brin said. “We’re talking to advertisers about using Google for all kinds of advertising,” added Schmidt. For instance, Volvo, Procter & Gamble, and OfficeMax all placed image and video ads on Google’s networks.

Google’s rapidly adding new places to advertise as well, with more to come this year. It bought the video phenom YouTube last October, and it has done deals with radio stations and newspaper groups to handle local ads. “Anything Google’s selling, we’re buying for clients,” says Bill Wise, CEO of Did-It Search Marketing.

Schmidt even implied that television advertising was ripe for Google to handle. He said Google’s targeting technology can “really apply well” to TV, and allow television stations to charge much higher rates for that targeting. He said there was an opportunity for Google to use data from TV settop boxes, which have unique Internet addresses, to do that targeting.

Beyond its evident expansion into new territory, Google has also simply continues to outmaneuver competitors such as Yahoo! Inc. and Microsoft Corp.--on both search and accompanying ads. Despite those two companies’ efforts to catch up—Yahoo! with Project Panama, a new search ad ranking system that starts rolling out in February--Google is expected to capture two-thirds of the search ad market this year, according to the e-business research firm eMarketer. “When a company starts advertising, it tends to go one place, and that’s Google,” says John Aiken, managing director at Majestic Research.

Google’s fourth-quarter results raised a couple of concerns, though none major. Its so-called traffic acquisition costs, or TAC, which it pays back to partners, looks to rise this year. That’s because it may have to pay more to recent partners such as eBay and News Corp.’s MySpace, as well as other new partners as it moves further into radio and video advertising this year. “We may see additional pressure on TAC rates,” said Chief Financial Officer George Reyes.

Google also spent heavily on some new initiatives. Google Checkout, its payment system, ran widespread promotions, offering consumers up to $20 off purchases to try it out and giving sites using it a break on Google ads. The company said that helped get a quarter of the Web’s top retailers to use it. Moreover, they found that Google Checkout logos prompted more people to click through on ads, benefiting those merchants. But Reyes said the promotions essentially cost the company one percentage point in revenue growth.

And Google’s capital spending continued at a fast pace. It totaled $367 million in the quarter and $1.9 billion in 2006, mostly on data centers, servers, and networking gear. The company said it expects to continue making “significant” capital expenditures this year. Moreover, the company hired nearly 1,300 people in the fourth quarter alone, up 14%, and analysts expect that growth to continue.

Ultimately, analysts also want to see Google diversify its revenue stream, which remains 99% advertising. In coming weeks, for instance, Google’s expected to introduce a paid version of its corporate office-productivity services, called Google Apps for Your Domain. But such initiatives will take awhile to develop. For the time being, though, Google appears to have many more opportunities than challenges.

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