Last Updated: May 12, 2008: 11:59 AM EDT
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Where does Google go next? (page 2)

By Adam Lashinsky, senior writer

At Google, what you often end up with instead of resource allocation is a laissez-faire mess. Take, for example, the hassles Dave Girouard had to face. Girouard is vice president in charge of Google Apps, the company's fledgling initiative to sell Web-based software applications to businesses. He wanted some alterations to Gmail to make the e-mail product more appealing to his corporate customers. To do that, he needed to lobby Gmail engineers, who don't work for him. He likens his efforts to a Peace Corps mission: all heart but little power to enforce his will. Yet while Girouard is begging for engineers, others, like the Ooyala founders, get blank-check offers. Says one ardent, if critical, Google fan: "They can't do everything, but they still think they can."

The dabbling often results in duplicated efforts - or products stuck in also-ran status. Google Page Creator, an early-stage product that nevertheless was publicly released in 2006, does about the same thing as Google Sites, a newer offering. "Even on Web search, there were multiple teams working on similar projects," says Ooyala's Knapp. Google Checkout is a payment system in which Google has invested heavily, yet it remains far behind eBay's (EBAY, Fortune 500) PayPal unit in market share. It doesn't help matters that eBay is a major Google customer, but that's another story.

Even high-profile business deals don't always reflect a clear logic. When the company outbid Microsoft to supply search ads to News Corp.'s MySpace social network, for instance, Google was aware that the deal wouldn't make it a lot of money right away. Almost two years later Google still isn't making much, if any, money on MySpace - or any other social network, for that matter.

Google also has yet to see the kinds of financial returns it had hoped for from its prodigious acquisitions. In its first significant purchase Google paid $98 million in early 2006 for dMarc, a startup that manages ad spots for radio. It was to be the foundation for Google's move into selling forms of advertising other than plain text ads. But dMarc, now Google Audio Ads, hasn't amounted to much. Indeed, it's one of seven products, as Google dryly notes in its securities filings, that have not produced any material revenue. Another of those products, surprisingly, is YouTube, which Google acquired in 2006 for $1.6 billion and which continues to experience torrid growth. According to comScore Video Matrix, YouTube's share of video on U.S. websites is now 34%, double what it was in February 2007. Yet Google has been relatively ineffective at selling ads on YouTube, collecting about $100 million in revenue in 2007, mostly from ads on YouTube's home page. Google says it's focused on growing share and improving the "user experience." Industry wags suspect that advertisers simply see little value in selling their wares next to dancing cats.

Google does have some big bets that could become meaningful businesses. Google Apps, a Microsoft Office lookalike package, is a modest success, with expected 2008 bookings of "several hundred million dollars," according to Google. That's still tiny compared with Google's main search-ad business, and it's downright microscopic next to Microsoft's $19 billion Office franchise. Another initiative with serious potential is Google's Android project, which offers a standard and open operating system for cellphones, compared with the proprietary systems in use today. Important industry players such as T-Mobile and Samsung have signed up with Google to be partners on Android.

Google's biggest bet so far is its recent $3.1 billion acquisition of DoubleClick, a specialist in online display advertising. Display ads are like what you'd find on TV or in magazines: They're focused on image and message rather than on transactions, which is the allure of text ads. Online display ads have grown more slowly than search ads, but they are a huge untapped territory. In the traditional ad world, brand advertising is far bigger than direct marketing. Same deal online. When people are on the web, most of the time they're not searching- they're reading, watching video, playing poker, whatever. There's big bucks in getting ads in front of people while they're engaged in all their nonsearch activities. Google hasn't excelled at such ads; DoubleClick has. (Disclosure: My wife is a former DoubleClick, and newly minted Google, sales executive.)

Google's move into new kinds of advertising opens up another thorny issue: the economy. In mid-2007, Google's chief economist, former University of California professor Hal Varian, read that Schmidt had referred to Google as "recession-proof." He quickly corrected his boss: "I would say recession-resistant," says Varian. In fact, Varian ran an analysis of Google's business to determine the effect of the overall economy on its performance. His conclusions were contradictory. First, he found that Google has a "GDP beta" of one, meaning that because the company's ad base is diversified, its business should swing according to the overall economy. That would seem to be troubling. Yet Varian also determined that because Google is so successful at targeting its ads- advertisers who buy the phrase "digital camera" on Google are highly confident they'll attract digital camera shoppers - it will be less susceptible to economic trends. Furthermore, because Google caters to advertisers who buy in small increments, Varian thinks the company's offering appeals in price-sensitive times. His overall conclusion: "There is something of a contra-cyclical nature" to Google's business. What's more, the massive shift underway from traditional media to online will trump any effects Google might otherwise feel from a weak economy.

As of this spring, the balance has swung in Google's favor. Fears that a slowdown in the growth of users clicking on Google's ads would lead to worsening performance have so far proved unfounded. When Google reported first-quarter earnings of $1.3 billion, significantly beating Wall Street's estimates, the stock jumped $90 per share in a day. A slowing economy simply hasn't affected Google's performance. "We've looked at this really carefully, and we do not see an impact as of this time," Schmidt told investors on April 17. "Should the economy change, we're well positioned to continue to do well because our model is so targeted. And targeted advertising does well in pretty much most scenarios."

So far the facts bear Schmidt out. But there's that bothersome conclusion of his economist, the one where Google's performance at some point mirrors the economy's. The question is, when?

For all its challenges, Google obviously remains a phenomenon. Its people may be wasting resources chasing disparate dreams, but the engineers dedicated to tweaking and improving the search algorithm and the ad system that cashes in on it are among the best in the world. Google's share of U.S. search queries just keeps rising: It's now around 59%, up from 46% in early 2005, according to Nielsen Online. "We are in one of our most productive phases," boasts Schmidt.

Also remember just how profitable Google is - and what a cushion that provides. Net margins of 25% place Google between Microsoft's monopoly margins of 28% and Cisco's (CSCO, Fortune 500) best-in-class hardware profits of 21%. Should Google ever decide to cut costs, it will have ample opportunities. As an example, the company spends at least $14 per employee per day on all that free food. At 19,000 employees, that works out to $67 million a year, or about 20 cents per share that would drop to the bottom line if Google were to have the temerity to ask its workers - shudder - to pay for their own meals. Twenty cents is a trifle; analysts expect 2008 earnings of nearly $20 per share. But in a pinch? No-brainer.

Then there's the possibility that Google truly is inventing an entirely new way of doing business. "People are labeling them as just about search," says Bruce Jaffe, a former M&A executive at Microsoft who came to admire Google the hard way- by competing against it. "But I'm not sure that's accurate. They've introduced a new model for software. Think of it this way. If they are a household brand on products like Google Maps and Gmail, that may be more than just search." In other words, getting customers to use Google all the time would make it ubiquitous on the web, as Windows is on PCs. "It may be that they're in a whole other world from everyone else," says Jaffe. "They could be such pioneers that no one will know for years."

Even if Google does not redefine business as we know it, the company will change. Companies inevitably do as they grow and age. They lose their coolness, they bureaucratize. But expect Google to keep doing things its way for as long as possible. After all, its founders still control 58% of the company's voting shares and have vowed to invest for the long haul rather than heed criticism about short-term performance. In that regard, it's interesting to get a sense of the way Google sees itself. When Schmidt is asked how he as CEO balances the need for process with the less quantifiable demands of experimentation and innovation, he responds by relating the thoughts of Page and Brin. "Let me give you the argument that Larry and Sergey have made, which is, I think, surprising," Schmidt says. "They are concerned that the company is becoming too conservative. They say to me, 'We took huge risks when we had no cash. Now we have all of this cash and we take few risks.'"

Think about that. Google recently made headlines by bidding almost $5 billion in a government auction of wireless spectrum, even though the company had no plan for using it. Some of its more peculiar products include Google Sky, Google Mars, and Google Ride Finder. It has become a significant investor in alternative-energy projects. Yes, alternative energy. And its founders fret that its risk-taking days are over? Then again, Google's biggest risk may be recreating the magic it enjoyed as a startup- that intangible quality that makes Silicon Valley tick. Paul Buchheit, the former Google engineer who is on to his second startup now, recalls what he loved about Google's early days. "I was always so excited at Google, because I didn't know what would happen next," he says. "Then I knew what would happen next." Predictability is a virtue in the world of big business. It's just not particularly Googley.

Reporting by Doris Burke and Yi-Wyn Yen contributed to this article. To top of page

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