There's a faint wisp of smoke rising from the AdWords system. Can Google fix it, or will the system break down?
A version of this article originally appeared on our US site, Fool.com.
Google (NASDAQ: GOOG.US) 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 any more.
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 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. In 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 them 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.US), for which each product must be perfect and then stays in high rotation for at least a year. Microsoft (NASDAQ: MSFT.US) gets a little bit closer with its multi-year 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 saviour 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.
> The Fool's latest report has just been published! Make sure you don't miss '10 Steps to Making a Million'-- it's free!
More on US shares:
> Both Anders and The Motley Fool own shares in Google.
