• by Daniel Frankel , May 20, 2008

Google expands amid concerns that have been dubbed Fear of Google (FOG), a seesawing financial outlook and what seems to be an effort to remake the Internet in its own image.

It was a sudden, startling display of vulnerability, akin to Xerxes getting stalled at Thermopylae, or Rocky Marciano getting knocked down by Archie Moore. Happily for Google, it rallied just like those guys did.

For the first three-and-a-half months of this year, the Mountain View, Calif. Internet company was certainly down, its shrinking market cap getting handed to it every day on Wall Street. In fact, Google's stock tumbled a whopping 35 percent - negating all of 2007's explosive gains - on reports that its core business of selling ads based on Web searches and charging by the click had suddenly stopped growing.

But the reports about the demise of paid clicks got it wrong.

During a first-quarter earnings report, Google revealed that the growth rate for paid clicks had in fact slowed a bit, to around 20 percent. However, based on the company's overall 42 percent revenue bump, it also proved its earlier claims that tweaks to the paid clicks biz - such as shrinking the amount of hyperlinked space around text ads - had indeed allowed the company to yield significantly higher CPMs per click. With its share price rebounding sharply, GOOG, as it's known in the investment trade, was back. Still, this wild ride put its awe-inspiring power in perspective.

Despite broadly dispersed and wildly ambitious endeavors - everything from scanning all the world's books and photographing everyone's houses in order to build giant databases, to infiltrating traditional media ad sales - Google's revenue is still almost entirely determined by high-yield Internet advertising.

Google's rare moment of humility also showed that any failure, however fleeting, to produce extraordinary returns through online advertising will produce an immediate and parallel downward reaction among ts investors.

"The biggest challenge for Google, from an investor standpoint, is that it's still a company with around 85 percent gross margins. That's the good news and the bad news," says Global Crown Capital analyst Martin Pyykkonen.

Publicly traded since Aug. 19, 2004 - and reporting a 57 percent revenue bump for fiscal 2007, to $16.6 billion - investors have never known a Google that doesn't grow explosively, and they certainly don't want to get to know one. That means that Google - despite a Valley-bred culture that prefers to keep its investors at continent's length - can't just get into any businesses it wants to. It has to find things that are proportionately explosive.

Going forward, the juice will likely be sustained through endeavors that support the high-margin Internet HGH that got it big in the first place - online advertising in foreign markets now generates more than half the company's revenue, for example. High-margin yields are not going to come by the company transforming itself into a kind of "Googlevest" and invading the scatter market, or getting into the cratering newspaper business - despite long-held rumors that it will buy The New York Times.

"The days of Google just spraying it around are over," says Ross Sandler, analyst for RBC Capital Markets. "They've taken steps to rein in operating-expense growth in recent quarters. And what they're going to do now is work on areas that are showing a lot of traction and cut down on areas that aren't showing as much."

Fear Factor

In 2006, shortly after Google presented a PowerPoint slide at its invitation-only investors conference in Mountain View that essentially read "Target: Global Advertising Market," an analyst somewhere coined an acronym that caught on: FOG - short for "Fear of Google."

Certainly fear is a natural, healthy instinct when a company develops a market cap that, even when the stock is tanking, is still bigger than that of Time Warner, Viacom, CBS, the New York Times Company and Publicis Groupe combined. Google made most of its $16.6 billion in total revenue last year in a global online advertising market that spanned about $45 billion, according to several estimates - dominance by any measurement - so media agencies and broadcasters probably have been justified in their panic.

And for Google, action has followed AdWords.

Two years ago, Google paid a reported $200 million to acquire dMarc Broadcasting, which specialized in the automated placement of primarily low-value, unsold radio inventory on a finite number of stations. Google had hoped to grow dMarc into a billion-dollar operation that blended seamlessly with its wildly lucrative AdWords online business. Revenue thus far has been limited; Google has been unable to expand the number of markets or the quality of inventory and advertisers amid continued antipathy for the tech giant in the radio biz.

Faring slightly better is Google's TV advertising foray with EchoStar, which lets advertisers upload their own 15-, 30- and 60-second spots, then purchase ad time via a Web interface - good slots, not remnant inventory - on the Dish Network feed for cable channels such as Nickelodeon, GSN (the Game Show Network) and Current TV. While sales volume is still miniscule in the grand scale of Google's balance sheet, the trial has intrigued advertisers and networks alike with its ability to cull valuable second-by-second viewer data from Dish Network's advanced set-top boxes.

Programmers "are at the point now where they're saying more measurement is actually good," said Google ad exec Tim Armstrong at December's UBS investor conference in New York. "They know they're providing ROI, but they think it would be great to actually prove the ROI in a new way."

Amid the trial expansion on Dish, rumors in the investment community have been stirring for about a year now that Google is on the cusp of a major acquisition to solidify its position in TV advertising. Speculation has centered on Spot Runner, a company with an established infrastructure for allowing small advertisers a cheap, Web-based means of creating TV spots using pre-fab templates, then buying time for them online.

Automated for the People

"We've heard very good things about where Google is going," says RBC Capital's Sandler, noting the interest of direct-response-oriented advertisers in such TV-spot auctioning, specifically higher education giant Apollo Group.

Regardless of Google's ability to develop this kind of efficient TV ad-buying alternative for smaller fish, Sandler questions the company's ability to compete with large media agencies for big brands, at
least in the near term. "Buying a certain type of ad on the cheap via Google is perfect for a certain type of client - they're not there to build a brand like Coke," Sandler explains. "The big brand guys advertise under a different metric with different goals."

Indeed, there has never appeared to be in Google's cold, algorithmic heart any inclination to get too involved with the human-level strategic planning that media agencies specialize in. Heck, Google doesn't seem to really want to even pick up a phone.

Notably, with dMarc, Google has been criticized for attempting to take automation to a new level, pushing to limit the number of sales reps on hand to walk new and prospective clients through the computer-driven process.

The broader world of broadcast and cable TV sales doesn't seem willing, at least yet, to cede human interaction. "It takes the sales out of the sales process and lets someone else control your inventory," says one cable network sales exec, voicing his disapproval of such automated auctioning. "You're posting your inventory for sale, but it doesn't allow you to develop customized opportunities in a traditional way that makes the business work for your client."

The TV ad-buying "business is so relationship-oriented," adds Standard & Poor's analyst Scott Kessler. "It's very difficult to implement new solutions in a business where people have done things the same way for decades."

If "relationships" are what Google needs to compete with media agencies for big TV accounts, the company has about $13 billion in cash on hand, so it could probably buy those through acquisitions and poaching if it wanted to.

DoubleClicking Down

Of course, Google is first and foremost an online media company. And besides, there's only so much complexity it can integrate at once, regardless of its impressive operational aptitude. And right now Google has its hands full, Sandler says. Its recent $3.1 billion purchase of DoubleClick was a game-changing move, threatening to negate one of the few areas where Google's chief rivals, Yahoo and Microsoft, have an advantage: Internet display advertising.

Google already controls more than 60 percent of the search ad market, and the acquisition of New York-based DoubleClick immediately delivers it the Internet display-ad business of such huge clients as General Motors, Coca-Cola and Nike.

"Google has had more success penetrating the smaller, long-tail of the network, but this adds a nice premium to that strategy," Sandler says. "They can start selling ads on big, household-type Web sites as opposed to a niche, say, mountain bike Web site that gets only 100,000 hits a year."

And while DoubleClick's use of spyware has sparked plenty of criticism in the past, its ability to know a lot about its customers fits in spectacularly with Google's pioneering addressability efforts.

"Google is a company that - if you peel back the layers of the onion - is really about taking data, analyzing it to its fullest extent, then leveraging a way to make money on it," Kessler says. "DoubleClick will enable them to gain immediate insight into what's working and what's not in the online advertising world."

In fact, despite the company's efforts to thwart Microsoft's attempted merger with Yahoo, analysts believe the DoubleClick acquisition puts Google in such a strong position that even a bigger, combined rival just wouldn't matter that much.

"You're basically putting a weaker No. 2 together with a weak and distant No. 3, and unless you pull a rabbit out of a hat, you're just not going to put that much competitive pressure on Google," Pyykkonen says.

All over the App

No less pertinent than display advertising to Google's long-range strategy are the company's efforts to control search and advertising on the mobile Internet.

The morphing, often nebulous business strategy surrounding Google's development of the open-architecture wireless platform called Android began to take a little shape in February, when Google was outbid by Verizon $4.74 billion to $4.71 billion in the federal government's auctioning off of the analog broadcast TV spectrum.

Google got what it wanted, driving the price Verizon paid high enough to trigger provisions ensuring that any service using these airwaves will be built on open-architecture technologies ... like, say, Android.

"Google wants to create a platform by which anyone can develop anything for the mobile phone as long as it's done on top of their operating system and as long as Google is the default search mechanism on these handsets," Sandler explains.

Beyond seeking to be the foundation of all wireless applications, Google has longer-term ambitions of changing the way software is distributed and used.

"The long-term vision of distributing software via Google's infrastructure is where this thing is going," Sandler says. "Google is getting into a ton of different areas, and software is where they're tiptoeing around but will probably get more serious about over time. Part of the reason why Microsoft wanted to acquire Yahoo is the fear that one day Google, which already has collaborative workplace software, will eventually have every application Microsoft produces and sells."

Under Google's model, all software and associated files would live on the network and be available for free to users. Google, in turn, could sell any advertising space that might live on these applications - say, on a toolbar - and it would control any Web searches done while a user had these tools open. "That's why Microsoft now feels it needs an ad-supported business to compete," Sandler adds.

Building its own Internet

Finally, beyond dominating software, search and online ad sales, Google is far ahead of everyone else in building the kind of network that can support convergence.

Spinning off millions and millions of dollars in profits with what is perhaps the best core business in the world right now, the company invests, on average, $8 million to $9 million every quarter on network infrastructure improvements.

"That's an absurd number, and when the Web goes from being primarily text-based to video-based in a couple of years, and all of the legacy portals start breaking down with bandwidth problems, it'll be so well-positioned," Sandler says. "You'll watch a video on Yahoo, and it will start to bog down. Then you'll watch the same video on Google, and bam. Right now, Google is essentially building its own Internet."