Technology

Google's Profit and Sales Leap, Firing a Rally


A big earnings surprise confounds analysts, who hadn't reckoned the Web search colossus would contain its costs so well

Google has defied the skeptics. The Web search leader reported third-quarter earnings that far exceeded the expectations of analysts, especially those who thought the company might finally fall victim to the slumping economy. Thanks largely to having contained costs better than in previous quarters, Google reported on Oct. 16 that profit rose 26%, to $1.35 billion, significantly higher than analysts had predicted. Sales jumped 31%, to $5.54 billion.

Relieved investors propelled the stock higher by as much as 10% after the results were released. The rally followed a 4% gain, to 353.02, which mirrored a broader market surge in regular trading. Until Oct. 16, Google's stock had plunged 53% this year.

In a conference call with analysts, Google (GOOG) executives sounded the familiar, confident notes of the past several quarters. "The economic situation today is globally worse than what people were predicting just a month ago," CEO Eric Schmidt said. "But we're optimistic about Google's future." The comments resembled those of about a month ago, when Schmidt said the "drama is in New York, not here," and "it's business as usual at Google."

Analysts Had Cut Targets

Schmidt's remarks—and the numbers that back them up—underscore Google's resilience, even as growth slows in overall online advertising. Search-related ads, which make up the bulk of Google's sales, appeal to advertisers because they reach customers ready to buy and because their results can be measured, analysts and Google executives say. "Advertisers are willing to take all the clicks we can give them" at current prices, Hal Varian, Google's chief economist, said during the conference call. A recession will prompt consumers to use search even more frequently to find deals, Varian said.

Google's profit per share, before stock option expenses, was $4.92—17¢ over expectations of $4.75. Net revenue of $4.04 billion, after payments to partners that run Google ads on their sites, was just a hair below the $4.06 billion expected by analysts. However, many analysts were informally assuming earnings might undershoot previous forecasts and have been reducing estimates and price targets in recent weeks.

Much of the earnings surprise came because Google slowed expense growth. The company hired 519 people in the quarter, compared with 2,130 a year earlier. It also reduced once-rampant capital spending by 18%, to $452 million. "Across all categories of expenses, people have been very diligent" in watching costs, Chief Financial Officer Patrick Pichette said. Rob Sanderson, an analyst with American Technology Research, said investors are relieved that Google is willing to keep a lid on expenses to buoy profit.

Online Advertising: Slowdown Evident

While growth in the U.S. continues at a respectable pace, some analysts saw cause for concern in Europe. Although most regions experienced "solid" growth, according to Pichette, revenue in Britain rose only 17% from a year earlier, compared with a 29% gain in the second quarter. "That is going to spread into Continental Europe," Sanderson says.

Google beat forecasts despite a negative impact from the strengthening dollar, which reduced effective earnings because of Google's significant international business, which accounted for 51% of sales. That's likely to continue into the fourth quarter and next year, even with a currency hedging program that began last quarter.

Encouraging third-quarter results aside, Google may not be able to withstand the headwinds of a protracted recession, which economists see as increasingly likely. "We're starting to see evidence of a slowdown in online advertising," says Jonathan Weitz, an analyst at Interactive Broadband Consulting Group. Recent Interactive Advertising Bureau figures showed the first quarter-to-quarter decline in ad spending since 2004, Weitz noted. A recession could affect even search advertising, especially because it is driven by small and midsize businesses—which may be especially hurt by falling consumer demand and a scarcity of funds as banks curtail lending.

Search Ads Keep Selling

And even if companies keep spending on search ads, it's possible that consumers who click on them will end up choosing to buy less frequently. This, in turn, would make the ads less effective for advertisers, who could then bid less for ads placed alongside Google's search results. A new study by search marketing firm SearchIgnite, for instance, found a trouble spot: Retailers in particular are starting to reduce search ad spending, which slid 10% in September.

For now, however, overall search-related advertising is holding up, and that's good news for Google. "Search is not immune to macroeconomic gyrations," says Craig Macdonald, vice-president for marketing and product management at Covario, which makes online-marketing analysis software. "But [Google] will be the last to be affected," he adds. According to SearchIgnite, overall U.S. spending on search ads rose 27% in the third quarter. "Our clients continue to want to spend on search," says Kevin Lee, CEO of search marketing firm Didit.com. "Like it or not, paid search is the front door to your store."

Another reason Google's results may not reflect the larger picture in Internet advertising is the company's sheer dominance. Covario estimates that Google accounted for nearly 83% of search ad spending in the U.S. and more than 95% in Europe. Because of that lead in one of the fastest-growing segments of Internet advertising, the results shed little light on the broader market—in particular on the climate for Yahoo (YHOO), which reports its third quarter on Oct. 21.

Given the market meltdown of the past few weeks, Schmidt conceded that the economy is in "uncharted territory." As a result, analysts may remain cautious on Google's prospects. "There's a lot of doubt about whether the 2009 estimates are too high," says John Aiken, managing director of Majestic Research. Currently the consensus is for 23% revenue growth. Aiken thinks that 20% is more likely, and even 15% is possible. But for one more quarter, at least, Google has held the bears at bay.


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