Google keeps its one-trick pony healthy

Google gets knocked for being a one-trick pony--the vast majority of its revenue comes from search advertising--but its strong fourth-quarter results showed what can be done by making sure cultivation of that business isn't hurt by diversification efforts.

The company on Thursday reported net income of $382 million for the quarter, a major drop from $1.21 billion from the year-earlier quarter. But that apparent drop was mostly because of two non-cash charges writing down the value of investments in AOL and Clearwire by $726 million and $355 million, respectively. Factoring that and some other charges out, the company had net income of $1.62 billion, well over analyst expectations, with revenue excluding commissions rising 4.5 percent to $4.22 billion.

Wait a minute. Wasn't there supposed to be a recession happening or something? How did Google do well, if not actually knock the ball out of the park?

In short, Google had two things going for it. First, people performed more Google searches. Second, when they did, Google showed the search ads more often.

Google makes money when people click on the textual ads next to search results; advertisers bid against each other to have their ads shown when people search with particular keywords. More searches obviously means more opportunities to show ads, and the company had "strong search query growth," Chief Executive Eric Schmidt said on a conference call.

Keep searchers coming
To keep searchers coming, Google has to keep its search engine competitive. The company made more than 350 improvements to it in 2008, said Jonathan Rosenberg, Google's senior vice president of product management. And Google has been turning up the volume knob on what calls universal search, the blending of video, book excerpts, images, news, blog postings, and other material besides Web sites into search results.

"We tripled the number of queries that triggered different kinds of results," Rosenberg said of 2008.

Google still sees plenty of room for improvement in search, though. "Wouldn't it be nice if Google understood the meaning of a phrase and not just the words you type?" asked Schmidt. And the company wants better search from mobile devices.

Keep advertisers paying
On the advertising side of the equation, Google must balance two forces: showing lots of ads versus showing better ads. High-quality, relevant ads are more likely to draw clicks and to train people that they should pay attention to search ads, but focusing on quality at the expense of quantity can hurt revenue. Google has been adjusting its "coverage"--the fraction of searches that get ads--as it tinkered with quality levels and launched new technology to come up with relevant ads more often, but in the fourth quarter, coverage increased.

"Ad coverage dipped earlier in the year," but ad-matching improvements helped Google increase coverage, Rosenberg said. Coverage is now back to where it was at the beginning of 2008, he said, but now with better quality.

Bear in mind Google already was ahead of its top rival, Yahoo, with coverage. The big driver for Yahoo's search-ad deal with Google, a partnership that was squelched by federal antitrust concerns, was that Yahoo wanted to use Google's technology to show ads where its own showed nothing.

Cutting costs
Google's search-ad business subsidizes a sprawling array of services and projects, but the company is becoming more discriminating about what to support. It's closed many projects that didn't pass muster, even those such as with direct potential revenue such as Google's print-advertising system.

Schmidt declared Google showed "tight controls over most costs" in the quarter, "something that had eluded us, but we got it down now." Chief Financial Officer Patrick Pichette dodged a question about whether the cost cuts are mostly over or just begun, but so far it appears Google is more nibbling around the edges.

Added Rosenberg, Google pays more attention to how it spends its money with a careful review process. "The review process is now a part of how we do business," he said.

That's not to say Google isn't expanding. It's still betting heavily on online services such as Google Apps, its online competitor to Microsoft Office, and on Android, its mobile-phone operating system, and on many lower-profile projects.

Retaining employees
Employees, evidently, are another investment. Google has slowed hiring--the company increased its employee count by only 99, to 20,222 in the quarter--but it doesn't want to lose them to others who can offer better benefits. The fact that Google's stock price has plunged in the last year and a quarter meant many employee stock options became effectively worthless.

Stock options let employees buy company stock over a period of time at a price set when the options were granted. If the stock drops, these options are "underwater"; the more it drops, the less incentive they provide for employees to stick around as new batches of options become available. Schmidt said 85 percent of Google employees have at least some underwater stock options.

For that reason, Google offered an exchange program that lets employees exchange their worthless stock options for ones based on Google's current price--a move that Google expects to pay $490 million to fund over the course of the program.

"Part of the compensation is stock. That's how it happens in high-tech, and it needs to have some value over the long term," Schmidt said.

The big unknown
Google can control its technology and its expenses, but the economy remains a big unknown factor. Here, despite Google's contention that search ads offer a clearer return on investment and therefore are not as susceptible to tightened advertising budgets, Schmidt offered a new dose of caution.

In the fourth quarter, the economy was in "uncharted territory," Schmidt said, but now, "It's clear we're in a recession. We don't know how long this period will last."

One thing is apparent, though. Google has a strong business engine that produces abundant cash, and Google is working hard to keep that engine purring.