Google Disappoints the Street

On news of Q4 results, the Web search giant's executives admit to issues with advertising on social networks, and defend R&D expenses
Eric Schmidt, Google chairman and CEO. Pierre Verdy/AFP/Getty Images

It's not the economy, stupid. That was the message from one Google (GOOG) executive after another on Jan. 31 as they tried to explain why the company's fourth-quarter results failed to match Wall Street expectations. "We have not yet seen any negative impact from the rumors of a possible recession," Google CEO Eric Schmidt said during a conference call after the figures were released. "We are quite optimistic about '08, and our model continues to work very well," he added.

And it's not like Google had a big miss either. The owner of the most highly trafficked Web search engine said fourth-quarter profit rose 17%, to $1.21 billion, as sales jumped 51%, to $4.83 billion. But net revenue, the amount Google retains after paying a share to partner Web sites, was $3.39 billion, about $60 million less than Wall Street's estimates. Per-share earnings, excluding stock paid to employees, were $4.43, a penny shy of analysts' forecasts.

Reassurances aside, the stock dropped 6.9%, to $525.50, in extended trading amid concerns that an economic slowdown will cause marketers to curtail online spending, depressing demand for ads on Google and its partner sites. Questions over the health of online advertising have already dragged on shares of Google, which dominates the market with an estimated 42% share of all Web marketing dollars, according to Jeffrey Rayport, founder and chairman of Marketspace Advisory, a strategy consulting firm.

Advertising Dollar Doldrums

The problem, Google executives said, was at least partly social networks. Google co-founder Sergey Brin said the company has yet to figure out the best way to make money from advertisements placed on the millions of personalized Web pages on such sites as News Corp.'s (NWS) MySpace. "We had a challenge in Q4 with social networking inventory as a whole," he said. "I don't think we have the killer best way to advertise on social networks. Some of the things that we were working on in Q4 didn't really pan out."

Brin's statements hint that News Corp. may have bad news when it reports earnings on Feb. 4. Though Google places ads on some 20 social networks, including its own Orkut, MySpace is by far the biggest. Google paid News Corp. $900 million in August, 2006, for the right to deliver ads to MySpace's 70 million-plus users.

Alarming for some investors was a slowdown in the rate at which ads are clicked on. That's important because Google's income from advertising hinges in part on how often Web surfers click on ads. Google said paid clicks increased 30% from a year earlier, compared with a 45% increase in the fourth quarter of 2006. Schmidt said the company has been reducing the clickable area around ads to decrease the number of accidental clicks, thus making the ads more valuable to marketers.

Expense Accounts

Expenses for research and development, as well as personnel, which both increased faster than revenue, are also to blame. R&D was up 63% from the prior quarter, and spending on sales and marketing increased 65%. General administrative costs, including stock-based compensation such as options, increased 72%.

Google executives stood behind their R&D strategy, claiming such investment is necessary to fuel the innovations that keep Google a leader, plus enable it to fuel the online ad industry's growth. The company is counting on the measurability of search advertising—the business in which Google invests the most—to help it weather any economic downturn that encourages marketing cutbacks.

Chief Financial Officer George Reyes noted that because search marketing is targeted so closely to consumers' interests, it aids direct sales, and that he's confident ad budgets will continue to emphasize search-related advertising. "Direct marketing tends to be less affected," said Reyes. "I think that has been true in past recessions and I think that will be true again."

As optimistic as Google is for now, even Reyes acknowledged the company would "certainly" be affected if online shopping takes a hit. He also stressed that Google has not yet seen any such weakening.

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