In maturing market, how can Google grow?

But as the sector matures, the search powerhouse will be under pressure from Wall Street to find another billion-dollar business.

Google's closely watched public offering will raise $1.66 billion and gives the company a market valuation of $23 billion.

The company's worth is partially based on expected earnings of more than $1 billion this year from sales of simple text ads pegged to keywords used in Internet searches. But ultimately, it's an estimation of Google's ability to innovate as the market it currently relies on peaks.

"There's a natural ceiling to the category," said Pete Petrusky, director of new media at PricewaterhouseCoopers, an auditor that tracks the online ad industry. "Paid search will continue to drive this medium in the near term because that's where the eyeballs are. But longer term, there's more opportunity for creatively driven formats," such as display advertising.

Google's IPO comes at a turning point in the relatively short life of online advertising. After years of languishing, online advertising is a prosperous business again for Web properties like Yahoo and Microsoft's MSN Web portal. In the first quarter of 2004, online ad sales reached $2.3 billion--the highest quarterly figure since the industry was first measured in 1996 and up 40 percent from the same period a year ago. The rebound is thanks in part to the health of search-engine marketing.

Paid search accounted for 35 percent of the $7.3 billion in online ad sales last year, as opposed to 15 percent of $6 billion in 2002, according to the Interactive Advertising Bureau and PricewaterhouseCoopers. Year over year, the paid-search market rose 183 percent in 2002 and another 94 percent in 2003.

Plateau inevitable
Like any booming business, however, it will eventually plateau. Spending on commercial search will grow 45 percent year over year to an estimated $2.8 billion in 2004, according to Forrester Research, a Massachusetts-based market researcher. But by 2008, Forrester predicts, commercial search will only rise by 11 percent year over year to hit $5.6 billion.

Google is a microcosm of the trend. The company had posted double-digit sequential sales growth in every quarter since 2002. But its sales rose only by 7 percent in the three months that ended in June, according to a recent filing with the Securities and Exchange Commission.

Industry executives expect sales from search-engine marketing to eventually comprise 50 percent or 60 percent of the total online ad business. But at that point in coming years, brand advertising is expected to take on a bigger role online.

Greg Stuart, chief of the Interactive Advertising Bureau, said that search typically has appealed to direct marketers, who value the efficiency and accountability of pay-per-click ads. Now that search marketing has proven itself worthwhile to marketers, it has and will continue to attract traditional advertisers, he said, similar to trends in the burgeoning cable TV industry during the 1980s. "There will be continued growth in search. Then it will be equalized with brand advertising in rich media and display ads," Stuart said.

Google, whose founders railed against graphics-rich banners in its early days, has recently began supporting image ads for partner Web sites in what could be the first step toward shifting toward the brand-advertising business.

"The most interesting question is, 'What will Google do next?' They have to continue to radically grow the business to support the kind of the valuation they have," said Sharon Wienbar, a director at BA Venture Partners, the venture arm of Bank of America.

She said the biggest worry as a venture capitalist is choosing to invest in a business on a collision course with Google in a newfound category. "There are not as many businesses that are as a profitable as the one they're in," Wienbar said.

Exploring growth
Google is already venturing into new areas of search. It is testing desktop software for searching the Web, and it plans to build out services for local and personalized Internet navigation. It is also planning to widely introduce Web-based e-mail services, and instant messaging could be an obvious extension of communications services, industry watchers say.

Sources familiar with the company say that Google has built a vast server farm of more than 100,000 machines that can be used to solve any computing problem, and yet another venture could be to offer thin-client computing for consumers.

What's clear, however, is that there's room to grow in the digital advertising industry.

Sales from Internet advertising make up only a fraction of total U.S. ad spending, which was up 6.4 percent in the first six months of this year.

"People spend 20 percent of their media viewing time online, but only 2 percent of media dollars are being spent online. If you scaled media to time spent, it's a much larger market than it is today," said Wienbar.

Indeed, Internet consumption is expected to outpace that of magazines in the next three or four years, according to Jupiter Research.

Online publishers plan to milk the unique trackability of the Internet in coming years to improve its proposition to marketers. Monitoring tools and the ability to target ads based on user preferences are a rebounding trend among publishers. Video and other types of rich media ads are also becoming the norm as broadband becomes ubiquitous.

"The trends are the industry's friend," said Rich Lefurgy, a partner at Walden VC.