Don't Get Cocky, Google

If you're still partying over Google's (Nasdaq: GOOG  ) market-stomping quarterly report last week, consider me little more than a passing noisemaker. See, as much as I loved the report, one tiny thing was eating away at me over the weekend.

Let me show you how a few metrics have been trending, and then I'll explain why I'm worried.

Quarter

Network
Revenues (NR)

Traffic
Acquisition
Costs (TAC)

TAC/NR

Q3 2006

$1.04

$0.825

79%

Q4 2006

$1.20

$0.976

81%

Q1 2007

$1.35

$1.13

84%

Q2 2007

$1.35

$1.15

85%

Q3 2007

$1.45

$1.22

84%

All amounts in billions.

This may not make a whole lot of sense to you right now, but it will a few paragraphs later. Let's go over those columns. Network revenues consist of money that the search-engine giant books through its Google AdSense program. That's where Google serves up targeted ads on third-party websites of all sizes.

You probably know all about some of the bigger AdSense partners, such as Time Warner's (NYSE: TWX  ) AOL and News Corp.'s (NYSE: NWS  ) MySpace, but a lot of the member sites are also substantially smaller operations. In some cases, a solitary webmaster who's simply passionate about a particular subject might turn to Google AdSense as an automated way to monetize the website's traffic.

Network revenues have been growing more slowly than Google's overall revenues have, but that's not what's bugging me at the moment.

Next column? Traffic acquisition costs, which consist of both the money that Google returns to its advertisers and the money it spends to draw traffic to its own site. Google is kind enough to spell out exactly how many of the traffic acquisition costs consist of money that's going right back to its advertisers, so let's replace TAC with the figure for AdSense partner payments.

Quarter

Network
Revenues

AdSense
Partner
Distributions (APD)

APD/NR

Q3 2006

$1.04

$0.78

75%

Q4 2006

$1.20

$0.916

76%

Q1 2007

$1.35

$1.05

78%

Q2 2007

$1.35

$1.06

79%

Q3 2007

$1.45

$1.12

77%

All amounts in billions.

If you're a shareholder, you may find yourself applauding. After paying its pool of publishers a larger chunk of the ad revenue generated from their websites over several sequential quarters, Google decided to pocket a little more -- 23% -- this time around.

The problem? Well, put yourself in the shoes of an AdSense publisher. How happy would you be with a program if you found out that your piece of the action is shrinking? Google never discloses the percentage that it pays out to most of its AdSense partners, though it's understood that larger partners get a larger percentage than its smaller publishers do.

In fact, recent ad-distribution deals with dot-com heavies such as CNN and MySpace may have been at the root of the growing payout percentages to publishers until this latest quarter. Yes, 77% is still a generously thick slice, but it may ring hollow to publishers who got spoiled through the first half of the year.

Cracking the piggy bank
Don't get me wrong. The trend toward higher percentage payouts had to end eventually. It's just odd to see this happening as bigger partners are hopping on the AdSense gravy train. It's also troublesome to see it happening just as Google is pounding the table about its need to invest more in aggressive expansion.

Again, maybe you see elation where I see frustration. If Google can crack open its partners like a piggy bank whenever it's bumping up against hefty capital-expenditure tabs or risking a soft quarter, why shouldn't it do so?

Well, the problem is that AdSense partners don't have much of a choice at the moment. Microsoft (Nasdaq: MSFT  ) and IAC/InterActiveCorp's (Nasdaq: IACI  ) Ask.com have yet to roll out a similar mainstream product. Sure, Microsoft will seek out meaty ad-distribution partners such as Facebook, but it hasn't opened up the publisher floodgates with a program such as Google's AdSense or Yahoo!'s (Nasdaq: YHOO  ) YPN.

Ah, yes. YPN has been a dud. It's had a tough time wrestling away AdSense publishers. Quite embarrassingly, Yahoo! actually posted a dip in affiliate revenue this past quarter. The company recently scored deals with big players Cars.com and WebMD (Nasdaq: WBMD  ) , but it's fared poorly with the small-fry publishers that populate the Web.

Less cocky, more Rocky
Obviously, we're talking about more than just a shrinking raw percentage here. As long as Google watches over the largest online ad network on the planet, it's likely to continue offering the most attractive option to third-party publishers.

Rivals can upgrade their ad-targeting technologies, but that won't sway Google partners if more bidders are paying more for leads through Google.

But this is also where Google can't get cocky. It can't start squeezing its publisher base -- if that is, in fact, the trend that just started -- just because the partners may lack a desirable substitute. Google needs to keep its partner base happy.

Even if the AdSense program is a low-margin endeavor relative to the rest of Google, it's still a profitable way to unload excess ad inventory while populating the Web with "Ads by Google" tags that recruit future advertisers.

That's why it wouldn't be entirely outlandish to see the likes of Microsoft or Yahoo! offer up healthier payout percentages in the future, if only to make up for lost time as they continue to seek out motivated sponsor-seeking partners.

Respect the piggy bank, Google. You need it more than you think.

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