Google: Weathering the Storm?

The search giant's second-quarter results disappointed investors, but CEO Schmidt believes on-target sales indicate it is shrugging off the broader malaise

One quarter after defying skeptics with a surprisingly strong performance, Google released second-quarter results that disappointed investors. Earnings unveiled by the company on July 17 slightly missed analysts' expectations and sent Google's stock tumbling. Yet in spite of worries that Google (GOOG) may finally be succumbing to the economic malaise, sales were on target and the search giant held fast to assurances that it's seeing little impact.

Net income of $1.25 billion, or $3.92 a share, rose 35%, and income before stock compensation costs rose to $4.63 a share. Both fell short of analysts' expectations of $4 and $4.72, respectively. Net sales, after payments to marketing partners, jumped 44%, to $3.9 billion, a hair over what analysts expected, thanks partly to an $88 million bonus from favorable exchange rates.

Google CEO Eric Schmidt cited a "more challenging economic environment," but said he believes Google's business will continue to weather the economy's cold winds well. "All of us have anecdotal evidence [of economic troubles], but Google has done well, and we continue to believe we are in a good position even if the economy gets worse," he told analysts during a conference call.

Investors clearly aren't so sure. In extended trading, Google's stock was sagging about 8% after falling as much as 12% initially. Before the report, Google's stock had declined a little less than 1% even as the broader market rallied. The company's shares had risen about 20% in the past quarter, though they're still down about 25% for the year. "People are just nervous," says American Technology Research analyst Rob Sanderson, who called the quarter "solid."

Big Drop in Interest Income

Indeed, the key causes of Google's shortfall weren't indicative of a slump in demand. The Internet search giant incurred somewhat higher expenses driven by legal costs. The biggest impact on the results was interest income, which fell 65%, to $58 million, thanks to lower yields on its $12.7 billion cash hoard, diminished partly by the acquisition of DoubleClick.

The interest drop had an outsize impact on the bottom line, analysts said. "In all, it was a very good quarter," says Sandeep Aggarwal, an analyst with financial services firm Collins Stewart (CLST). "If not for the decline in interest income, [Google] would have beat the quarter by a lot." Other contributors to the drop in interest income include expenses related to foreign-exchange risk management.

Google also reported further slowdown in the number of clicks on search ads, a trend that dates to the second half of last year. Paid clicks rose 19%, a slowdown from 20% in the first quarter and 45% nine months ago. Google has attributed much of the decline to efforts it says are aimed at making ads more effective. It has reduced the number of search results that return paid ads by changing its formulas to discourage ads that link to sites that provide little useful content. Its first-quarter results had largely quelled worry about paid-click growth, and analysts appear unconcerned about the slowdown.

Hiring Slowdown

Wall Street also seems sanguine about Google's general and administrative costs, which rose 49%, somewhat more than expected, thanks to legal costs from Viacom's (VIA) lawsuit against Google's video site YouTube and various regulatory issues. The jump came despite a slowdown in hiring in the quarter, with 448 new hires, bringing the total to 19,604. "We don't need massive new [numbers of] people," Schmidt said.

Capital spending rose a relatively modest 21%, to $698 million, though executives indicated they would continue spending on computers and networking gear for the company's massive data centers.

Despite after-hours traders' disappointment, Google's results contrasted with warnings from two other companies focused on online advertising. Earlier in the day, ValueClick (VCLK), whose main business is funneling consumer leads to marketers, reduced its sales and earnings estimates, saying "the macroeconomic environment negatively impacted revenue in the quarter, primarily in the U.S. comparison-shopping and U.S. display-advertising businesses." ValueClick's stock fell 20% on July 17. On July 7, consumer-banking information company Bankrate reduced its outlook, sending its stock plummeting as much as 24%, to a 52-week low.

Yahoo! (YHOO) reports its second-quarter earnings on July 22, and Google's tepid results may be seen as a negative sign for the beleaguered Internet portal. A disappointing report from Yahoo could hamper that company's attempt to extract a better deal from unsolicited suitor Microsoft (MSFT). That battle, which also includes a proxy fight by activist investor Carl Icahn, is expected to come to a head at Yahoo's annual meeting on Aug. 1.

Gaining Ground on Rivals

Comparisons aside, Google is in something of a class by itself, thanks to its dominance of the most lucrative part of the online advertising business. Leading up to the earnings announcement, Google continued to gain ground on rivals. Its share of search queries rose to 69% last month, at the expense of Yahoo and Microsoft, according to market researcher Hitwise. Even more important, Google's share of search ad dollars rose in the second quarter to more than 77%, according to search marketing firm Efficient Frontier.

And in search advertising, market watchers say they aren't yet seeing a slowdown. "At some point the macroeconomic factors have to take a toll on search," says Richard Stokes, CEO of AdGooroo, a firm that provides competitive intelligence to search marketers. "But it has been growing so fast that this has been masked. Google will be insulated for some time from the overall economy."

The key reason: The greater measurability may appeal to cash-strapped advertisers more than brand-oriented display ads. "They prefer advertising that is measurable," says Roger Barnette, CEO of search marketing firm SearchIgnite. "The return that advertisers are getting on their search advertising is still healthy." If that continues, Google likely will remain healthy as well.

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