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Why did investors freak out about Google?

Three culprits conspired to hurt Google's stock: interest income, caution about the economy, and Google's overshooting the mark on screening out low-quality ads.

Investors punished Google for the less-than-stellar second quarter results it reported on Thursday, sending the share price down about 10 percent to $482 in Friday trading. So what went wrong?

No one thing was responsible, but a few factors combined to make a 35 percent growth in net income to $1.25 billion look like bad news.

Interest income
First, the company missed expectations: net income, excluding various items, was $4.63 per share, short of the $4.74 expected by analysts surveyed by Thomson Reuters, and that's usually enough to send the stock down in after-hours trading.

Google revenue continued its upward trajectory in the second quarter, but not to the satisfaction of Wall Street.
Google revenue continued its upward trajectory in the second quarter, but not to the satisfaction of Wall Street. (Click image to see larger version.) Google

But up at the top line, revenue was in line with expectations. One big reason the bottom line was at odds: interest income, the money Google earned off its cash pile, was lower than analysts had forecast. That income dropped to $58 million in the second quarter from $109 million in the first, a decline Google blamed on lower yields, a cash reserve shrunken somewhat by the DoubleClick acquisition, lower gains from sales of securities, and greater expenses hedging against foreign exchange rates.

Macroeconomic uncertainty
A second culprit is the slow economy. Google executives didn't come out and say they were hurt by slower ad spending, but they sounded more cautious overall than three months ago, when they all but said, "Economic slowdown? What slowdown?"

This time Chief Executive Eric Schmidt launched the call optimistically but with a note of warning: "Traffic and revenue have held up well despite uncertain economic conditions."

And Google brought chief economist Hal Varian onto the call to give some detail on the slowdown. Here's what he had to say about the situation in the United States: "The query growth has been positive in every sector we track, even including those sectors that are generally economically sensitive such as automotive, real estate, and travel. We also see that year-on-year revenue growth is positive in every major sector except for real estate, and even that one is only down by a small amount."

But it could be investors were spooked more than they should have been.

"While the company went to unusual lengths to highlight its relative strength in a weakening macro environment, we think simply by virtue of highlighting it, they may have created more confusion," said UBS analyst Benjamin Schachter in a research report Friday. "We continue to view Google's pay-for-performance model as somewhat resistant to an economic downturn (but not immune), and believe that the company could, in theory, even gain share during a downturn as advertisers look to consolidate ad dollars with a 'more measurable' solution."

Paid clicks
The third factor, though, was perhaps the most interesting, because it's the one that's under Google's control to an extent: paid clicks, which while increasing 19 percent from the second quarter of 2007 actually decreased 1 percent from the first quarter of 2008.

The vast majority of Google's revenue comes from selling ads that appear next to search results; the company is paid when searchers click on the ads, generating a paid click. Google tries to strike the right balance between showing low-grade ads on many search pages and high-quality ads on only a few. Erring on one side means that ads are often irrelevant to searchers or leave them dissatisfied when they click; erring on the other side means the ads are more valuable to searchers, helping to train people to pay attention to ads, but showing fewer ads means Google doesn't have has many opportunities to get paid.

"There is some evidence that I think we've been probably a little bit more aggressive in decreasing coverage than we ought to have been," co-founder Sergey Brin said.

Taking these factors together, some Wall Street analysts were less ruffled than investors.

There are favorable long-term trends that are grounds for Google optimism. "We continue to expect Google to gain search share and monetize newer initiatives such as YouTube and Google Apps over time. We are maintaining our 'outperform' rating," said Cowen analyst Jim Friedland, who also expects Google's search ad partnership with Yahoo to produce $100 million to $200 million in revenue in its first year of operation.

And Collins Stewart analyst Sandeep Aggarwal thinks the Google stock drop was out of line: "We believe post-earnings reaction was excessive and we would be buyers of Google on any weakness."