Did Google Just Break Its Cash Machine?

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Google (Nasdaq: GOOG  ) CEO Larry Page is "super excited" about "a really strong quarter," but investors don't seem to agree. Shares fell 8.5% on Friday after the company published its fourth-quarter results. The online giant saw $10.6 billion in raw sales, or $8.1 billion after deducting traffic-acquisition costs trickling down into $9.50 of earnings per share.

What's wrong, honey?
Many observers, myself included, were troubled by lower revenues per advertising click. It's enough to drive a nervous man distracted, I tell you. Should we all sell our Google shares before the whole advertising system explodes in our faces?

It's unusual to see that metric changing dramatically, and Google usually has a good explanation when it happens. For example, the company redesigned the way its text ads work in 2008 so that clicking on the white space around the text didn't trigger the link anymore.

Users found themselves clicking on fewer ads by mistake, which drove down the number of paid clicks but made for happier advertisers. Landing on an ad page you never intended to see doesn't convert into a whole lot of sales. Cost per click went way up. Later the same year, Google redesigned those ads to make them more pleasant to look at, thus boosting the click rates without damaging CPC much.

Business as usual
Big G makes small changes like this all the time, and the downsides to one change tend to be smoothed over by the benefits of another one pretty quickly. According to advertising VP Susan Wojcicki, Google implemented about 20 modifications last quarter alone. The unusual thing here is that lots of these moves pulled the volume-versus-profitability equation in the same direction, generating 34% more clicks year over year but at 8% lower cost per click.

When you think about how the AdSense/AdWords cash machine works, that makes sense. Advertisers basically bid on triggering search terms in an ongoing auction. Winners get their ads shown on your results page, and then they cross their fingers and hope to attract your attention.

In an equilibrium like that, the whole system becomes very dynamic. If Google suddenly gives ads in general much stronger eyeball magnets, the ad inventory clears out quickly, lowering prices. Slower volume means that each eyeball is worth that much more to each advertiser, so prices go up and you get a backlog of unsold ads.

So the trick is to raise both ends of the table in harmony so that you neither devalue your ad inventory nor scare away advertisers. Over time, the whole system should form a virtuous cycle, where more clicks attracts more advertisers and consumers feel more comfortable buying stuff off online ad links. The rich get richer.

That being said, let's have a look at Google's recent revenue growth.

Google Revenue Growth Chart

Google Revenue Growth Chart by YCharts

At the end of that chart, you can tack on the fourth-quarter revenue growth at 25.4%. Excluding TAC costs, it's 27.6%, indicating that Google works smarter, not harder, to get new customers. Either way, these are numbers that would have looked great a few quarters ago.

It's a setback but hardly a disaster. I a quarter or two, we'll forget all about this speed bump, just as I'm sure you had forgotten about the old white-space changes.

Cue Alanis
What it all boils down to is that Google is on top of the advertising system, always working to make it more efficient. You can't win 'em all, but this long series of rapid changes is set up to correct errors very quickly. Only the good experiments get to stay in production.

This is a radically different approach from Apple (Nasdaq: AAPL  ) , for which each product must be perfect and then stays in high rotation for at least a year. Microsoft (Nasdaq: MSFT  ) gets a little bit closer with its multiyear cycle of Windows releases, interspersed with bug fixes and service packs along the way. The much-maligned Windows Vista, for example, is really not that different from savior and successor Windows 7 after years of quiet improvements. It's just the tainted Vista brand that had to die. You could call the Windows development model a hybrid between Apple's slow-and-steady and Google's rapid iterations.

Having thought of Google's quarter in the context of the AdWords balancing act, I'm confident that the business model didn't just break. Cost per click should bounce back nicely in the coming quarters, and all will be right with the world again. But I'm still going to make darn sure that my thesis is right. I've been known to make mistakes before, and I don't want to get blindsided again if I can help it.

If you agree that Google's clicky troubles are temporary, this looks like a terrific time to buy shares. You just don't get an instant 8% discount every day. My own shares and my bullish CAPScall on Google are staying firmly in place. But if you disagree, there are other options. Just check out what Foolish analysts think might be the finest investment idea in 2012.

Fool contributor Anders Bylund owns shares of Google but holds no other position in any of the companies mentioned. The Motley Fool owns shares of Google, Microsoft, and Apple. Motley Fool newsletter services have recommended buying shares of Google, Apple, and Microsoft and creating a bull call spread position in Microsoft. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinion, but we all believe that considering a diverse range of insights makes us better investors. Check out Anders' holdings and bio, or follow him on Twitter and Google+. We have a disclosure policy.

Read/Post Comments (2) | Recommend This Article (2)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 22, 2012, at 1:07 AM, deasystems wrote:

    I don't give a damn about the top line, just the profit. And Google's profit growth this quarter was just 5% year-over-year. The company is spinning its wheels making a lot of noise and little progress...

    It's a bad bet.

  • Report this Comment On January 22, 2012, at 5:59 AM, H3D wrote:

    The comparison with Apple and suggestion that Google is somehow safe and Apple dangerous is absurd.

    Google pretty much has a monopoly on what it does, which has little inherent growth, but it seems incapable ad making money doing anything else.

    Google therefore must always execute perfectly on its one thread. There is little upside and do much downside.

    Apple competes in a number of markets and although it is a decent sized player in each one, there is still upside available from market share growth, or market growth, in all of the areas that matter.

    Apple therefore has significant upside to balance its downside, in each area. Multiple product streams with overlapping cycles. An enviable record of taking large and profitable chunks of new market areas in a very short time, and great user stickyness.

    Look at a two year chart. Google is neither growing, nor paying a dividend. So what is its purpose? What return justifies the enormous downside and minimal upside?

    Will Apple release a text based Siri as an openly available web page? Who knows. But I suspect that if it does, Google could lose a third to half it's search traffic in days.

    That's a much bigger step than Google was over Alta Vista.

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