Google's Great Expectations

After nearly a year of revenue slowdowns and cost-cutting, Google is gearing up to take advantage of a recovering economy.

Adding to a series of positive earnings reports from technology companies, the Internet search giant said on Oct. 15 it sees recovery in its core business of online advertising. Google (GOOG) has begun stepping up hiring and capital spending, as well as considering more small and large acquisitions. "We now have the business confidence to invest in the next phase of innovation," Google Chief Executive Eric Schmidt said on a conference call with analysts.

Google handily beat third-quarter earnings expectations. It said revenue that excludes payments to advertising partners rose 7%, to $4.38 billion—significantly higher than the $4.24 billion expected by analysts surveyed by Thomson Reuters (TRI). "We were all looking for acceleration in revenue growth from Google, and they delivered," says Sandeep Aggarwal, an analyst with financial-services firm Collins Stewart.

Net income rose 27% to $1.64 billion, or $5.13 a share. The more closely watched profit excluding items such as stock option expenses was $5.89 a share, also beating the average forecast of $5.42 a share. A year ago, Google earned $4.92 a share on $4.04 billion in revenue.

The results are the latest in a series of signs the recession is easing. In particular, technology companies have started reporting better earnings and providing more positive outlooks than they did earlier this year. On Oct. 13, chipmaker Intel (INTC) said third-quarter sales rose a better-than-expected 17% amid an improvement in demand for its products. IBM (IBM) also topped earnings forecasts on Oct. 15, though investors were disappointed that the computer services provider reported a decline in orders, a gauge of future business.

In contrast, Google investors liked what they saw, lifting shares about 3% in extended trading. The stock had slumped 1% amid a decline in the broader market on Oct. 15, before Google's results came in. Google's shares already had risen 67% this year, to an Oct. 14 close of 535.32, the highest in at least 52 weeks. Just in the last month, the stock has risen 12%, compared with a 3% gain in the tech-heavy Nasdaq stock market. Several analysts have raised Google's 12-month target price to above 600.

A Revival for Online Ad Spending Google's results may augur recovery in demand for online advertising, an industry where overall sales fell by more than 5% in the first six months of 2009. Search advertising has held up better than display ads, an area led by Internet portal Yahoo (YHOO), but search ads were still hit by the poor economy. Google's revenue growth had slowed to just 3% in the second quarter from a year ago, compared with 31% growth in all of 2008.

Now it appears marketers are starting to spend more on search ads, the snippets of text that appear next to and atop search results. Google said cost per click, the amount advertisers pay when people click on an ad, fell 6% from a year ago but rose 5% from the second quarter. Analysts took that as a positive sign.

Signs of a modest recovery in search advertising have been building in recent days. On Oct. 13, search marketing firm SearchIgnite said U.S. paid-search spending was down 1% from a year ago across all the search engines. But more encouraging, search ad spending rose 10% from the second quarter, much more than the usual 2% gain in the same periods in 2007 and 2008. Another search marketing firm, Efficient Frontier, surveying its own customer base, said U.S. search ad spending was up 5% from the second quarter, though it was down 5% from a year ago. "Search marketers are starting to get back in," Efficient Frontier CEO David Karnstedt said in an interview.

Analysts have been saying for months that as the economy improves, search advertising is likely to rebound most quickly among all forms of advertising because marketers can increase spending on it literally overnight. "We saw a significant uptick in search spending [in contrast to display ads] this quarter," said Bryan Wiener, CEO of digital ad agency 360i. "Marketers really saw the bottom at the end of the second quarter."

Expansion Could Curb Margins Google doesn't provide its own forecasts, but executives' comments were relentlessly upbeat. Wiener says plans by his clients indicate that while the fourth quarter will be up, the pace of growth will accelerate starting next year. He expects to see double-digit revenue gains next year, with Google the main beneficiary.

Analysts had few concerns about the quarter, but there was one yellow flag: Clicks on ads, a measure of their effectiveness, rose 14% from a year ago, but that increase was a bit under the 15% increase in the second quarter. Aggarwal says that indicates both that consumer demand hasn't entirely returned and that Microsoft's (MSFT) Bing search engine might have siphoned off some business.

However, Google doesn't seem to have lost much ground so far, despite a $100 million marketing blitz by Microsoft. Market researcher ComScore (SCOR) said on Oct. 14 that Google had gained 0.3 percentage points in September from August, for 64.9% of the market, while Microsoft gained 0.1 points, to 9.4%. Yahoo lost a half-point, to 18.8%. "Google's competitive advantage really seems to be reinforced," says Jeff Donlon, managing director of technology research for asset manager Manning & Napier, which counts Google among its top five holdings. "And there's still room for Google to take more market share."

Analysts also wonder whether Google's more aggressive stance on capital spending and hiring could hurt profit margins, though that didn't seem to rattle investors. In the third quarter, Google continued to keep a lid on capital spending and hiring. It reduced its workforce by 121 people, to 19,665, though Schmidt said that stance is changing. "We are short key technical talent to achieve some of these broader initiatives," he said.

Open to Strategic Acquisitions Google was also clearer than it's been in several quarters that it's on the prowl for acquisitions, which it can fund through its $2.5 billion quarterly free cash flow and a $22 billion war chest. "We're open for business in making strategic acquisitions both large and small," Schmidt said. In particular, he anticipates maintaining Google's traditional once-a-month pace for buying small companies. But he also mentioned Google might make large strategic acquisitions to gain large new audiences or user bases every year or two.

While search remains far and away Google's main business, executives repeated earlier statements that the company's video site YouTube is on track to be profitable in the "not-too-distant future." The company said 90% of YouTube's home-page ad inventory, its main revenue generator, sold out in the third quarter.

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