Behind Google's Glowing Earnings

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Analysts said they were pleasantly surprised by Google's results because the company's own moves recently had indicated it was feeling some pain from the economy. It has cut more than a half-dozen projects in recent weeks—most recently its Print Ads program. Google has also laid off 100 recruiters as it has radically curtailed hiring, and it may eliminate some engineers as part of announced office closings.

But Google Chief Executive Eric Schmidt told analysts during a conference call that Google was simply making prudent cost cuts in a tough economy. "We have the formula down now," he said. For instance, Google cut its capital spending by 46% from a year ago and 19% from the third quarter, to $368 million.

Google's Shrinking Workforce

The bigger cost controls came in human capital. Google increased its workforce by only 99 people, to 20,222, during the quarter, down from an increase of 519 in the third quarter and many more in previous quarters. It also cut several thousand contractors and temporary workers, and Chief Financial Officer Patrick Pichette implied that if things get worse, more staff cuts could ensue.

At the same time, Google took steps to retain employees, some 85% of whom have at least some stock options priced less than the shares' current level. Google said it would offer those employees the right to trade in their options for ones with a lower exercise price. This would give them a better chance to profit from a rise in Google's shares and make it less likely they would bolt for newer companies such as Facebook. Under the deal, which will result in $460 million in expenses, employees will have to wait 12 months longer than their original vesting dates to exercise them.

The bottom line is that Google is faring better than many of its peers. "They're not being outperformed by anyone," says John Aiken, head of equity research for Majestic Research. Indeed, earlier in the day, Microsoft warned that profit and revenue likely would drop in the next two quarters and said it will lay off 5,000 people over the next 18 months because of slumping demand in its software business. Microsoft also said it lost $1.6 billion last year alone on its online business. Yahoo, which reports fourth-quarter earnings on Jan. 27, recently replaced CEO Jerry Yang and is faced with an even steeper hit on its mainstay online display ads, on which marketers have cut back in favor of more measurable search ads.

The big question now, as the economy continues to decline, is what's next. On that, Google executives didn't provide specifics but implied that things could get even tougher early this year than they were in the fourth quarter. "We don't know how long this period will last," Schmidt said. "We're certainly prepared to get through this, no problem."

Search Ad Spending: More Declines Ahead

Yet it's clear that search advertising isn't immune from the deep recession. Efficient Frontier, which helps marketers run large search ad campaigns, said spending on search ads by its mostly large corporate customers fell 8% in the fourth quarter, the first drop on record. Smaller search spenders, however, cut their outlays by 23%. What's more, says Efficient Frontier CEO James Beriker, "the number of conversions [clicks that ultimately resulted in a sale] really dropped."

That's why some analysts expect search spending to decline even more in the first half of this year. Despite an expected uptick later in the year, it's possible search advertising could be flat this year, says Craig MacDonald, vice-president for marketing and product management at search marketing firm Covario. "The fourth quarter was pretty strong, but every single customer said that's not going to happen again in the first quarter," he says.

All that means Google still could get bitten by the troubled economy in the coming year. "People really didn't think Google was cyclical, and it is," says Aiken. "There are far fewer people buying digital cameras and the like—that's what it comes down to." If the economy worsens, even mighty Google could get whacked.

Hof is BusinessWeek's Silicon Valley bureau chief.