• by Diane Mermigas , October 15, 2008

The ongoing economic mess will topple Google from Mount Olympus this week. The Internet giant will be held more accountable to Wall Street and Madison Avenue for what it does and claims to deliver. It will attest to some of the growing pains afflicting the evolving online display, search and video advertising markets. And it will have to think more pragmatically without hyper-growth.

The signs are everywhere, including Google's struggle to secure regulatory approval of an ad alliance with Yahoo, and a stream of lower financial estimates from analysts ahead of Thursday's reported earnings. Investors are pressuring Google for more disclosure about its expansive research and development, capital spending and obscure financial forecasts. With consumers surfing the Web more but buying less online, and advertisers adjusting their keyword bidding and allocation of search dollars, Google is poised to take serious hits in a protracted global recession. While paid search is expected to hold up better than display advertising, many of Google's ad clients are companies that are lowering their financial projections and slashing their budgets. Late Tuesday, comScore reported Google's fastest year-over-year query growth of 35% in the third quarter.

RBC Capital reports that domestic paid search remained strong in the third quarter, despite economic troubles (although advertising is a lagging indicator). Retailers increased their search spend over the prior year, although intra-quarter spending fell from 20% growth in July to a 10% decline in September over the prior year. Google increased its search market dominance with more than 72% of the search ad dollars.

A worst-case scenario would have 2009 online ad growth fall by half domestically to 12% and by half internationally to 22%--yielding earnings growth of 2% for Google, compressing margins to 55.5%, holding revenue growth to 17% and pushing its stock price to $292 a share, according to RBC analyst Ross Sandler. He has reduced his base case 2009 estimates to 29% earnings growth on 21.5% revenue growth. And to think Google CEO Eric Schmidt told a press conference earlier this month that the company had not yet seen an impact from the credit crisis.

How much of this is macroeconomics versus natural deceleration is one of a handful of critical questions that Google executives must answer, according to Barclays Capital Internet analyst Douglas Anmuth. Fewer affiliate partnerships (MySpace), toolbar distribution deals (Dell) and advertiser dollars moving into search (especially from traditional and niche retailers) will exacerbate Google's law of large numbers deceleration. Slower growth is a given for major Internet players, as well as for any companies looking for digital interactive and online to shore up their deteriorating legacy business fundamentals.

At that point, does Google become an Internet bellwether rather than an exception? Google already is struggling with monetization of YouTube as well, squeezing the most out of every search to increase returns. In fact, analysts expect Google's AdSense network partners, especially in social networking, to continue to underperform. With more than half of its revenues generated outside the U.S., Google's exposure to volatility in international currency markets and the strengthening U.S. dollar (which it manages with cash-flow hedges) is troubling some analysts. Its foothold in the U.K., as a template for other countries, could be strained by mature search and economically squeezed markets.

Even as its annual gross revenues soar past $20 billion in 2008, it becomes more challenging to diversify revenues through display, video, mobile and applications. Google is still expanding its ad agency relationships, integrating its DoubleClick platform and attracting new content and advertiser support to YouTube.

A sleeper issue for Google is the stricter scrutiny or flat-out resistance that it could encounter from a possible Democratic presidential administration and Congress to its proposed search partnership with Yahoo, particularly if Yahoo merges with or buys Time Warner's AOL. The strategic value to Google from a Yahoo alliance exceeds the financial returns (an estimated $160 million in revenues in the first 12 months). A Yahoo-AOL merger would make Google a partner with both of the companies, creating a powerful new international online competitor--if they can pass the same tough regulatory muster.

Ironic or not, analysts expect Google to take a one-time impairment charge of about $500 million for its 5% equity stake in AOL when it had twice the value, or $20 billion. Google has more than $17 billion in cash and equivalents to do its own deals, including winning bids for WiFi white space. For now, it is working with the Department of Justice to hasten approval for its Yahoo alliance, most likely with caps.

In these trying times, Google will begin to act more like other companies in some respects. It will need to re-evaluate its workforce, operations, return on investments, employee perks and competition. As the spry giant, it can challenge Microsoft with a new Chrome browser while glancing backward at Amazon's ever-growing platform-savvy. Mostly, Google will continue to be able to effect digital change with its analytics and technology. It fundamentally must provide new, lucrative frameworks for advertisers, marketers, retailers and consumers to grow economically.

Google especially could put some of its algorithmic genius to work to help solve some of advertising-supported media's most vexing problems, such as the creation and management of accountable and actionable metrics. It could turn every click into a buy, as it is beginning to do with YouTube, and every buy into a strong argument for e-commerce. And it could continue to function as one of the true enterprising beacons for innovation, progress and creativity, forging the digital interactive frontier that in the end will prevail.