(FORTUNE Magazine) – When Eric Schmidt left his job as CEO of Novell to run Google last year, the reaction in Silicon Valley could be summed up in one word: Huh? Yes, Schmidt's four-year tenure at software giant Novell had been miserable and not particularly successful. But a dot-com? Surely he could have done better. Everyone knew Google was a terrific search engine, but few thought it had any chance of becoming profitable. Dozens of companies, including Alta Vista, Yahoo, Lycos, Excite, and Infoseek, had tried to build a business based on searches--and failed. Schmidt, a former Sun honcho, seemed to be making the same mistake as George Shaheen, who gave up his CEO slot at Accenture in 1999 to head a dot-com calamity waiting to happen called Webvan.

Today the rest of the world is beginning to understand that Schmidt, 47, wasn't crazy at all. His decision to bolt Novell can be compared to Meg Whitman's leaving Hasbro for eBay four years ago. Though Google is still privately owned, sources say that its 2001 revenues were in the neighborhood of $70 million; now they are rolling in at more than double that rate. Most significant, Google has managed to grow and become profitable. The number of employees has doubled in the past year, to nearly 400, and Google is earning money at an annual rate of more than $15 million. Schmidt and his team won't confirm that figure but do concede the following: If Yahoo, which is paying Google $7 million a year to use its search technology, doesn't renew its contract when it expires in June, the company will still be in the black.

Remarkably, all this has happened without the company's spending much at all on advertising. Google's popularity has been driven mostly by word of mouth. "They're the eBay of information," says Mary Meeker, Morgan Stanley's Internet analyst. "You go to eBay to find things that are hard to find. You go to Google to find information that is hard to find." Another eBay comparison that's worth mentioning here: Google is three times as profitable as eBay was at the same age--32 years after it was founded. Last year, at age six, eBay made $90 million on revenues of $614 million.

A lot of the recent optimism about Google stems from one event: In early May, AOL tapped Google to be its exclusive search engine and agreed, for a share of the revenue, to distribute Google's ads among its 35 million members. AOL (parent of FORTUNE's publisher) may have its own problems right now, but no one disputes that for online advertisers, AOL members are the most coveted audience in cyberspace. And for a small company like Google, a deal with AOL provides instant credibility. "Google was taking traffic from AOL and Yahoo, so AOL said, 'Let's have people use Google on our site, and maybe people won't be tempted to leave,' " says Piper Jaffray analyst Safa Rashtchy.

Almost from the day it started, Google has been something of a cultural phenomenon. Three months after incorporation it made PC Magazine's top 100 Websites for 1998, and its traffic has grown exponentially since then. Today it processes more than 150 million searches a day, or about 1,800 searches a second, in 74 languages in 32 countries. People use it for everything from academic research to espionage.

Google's headquarters in Mountain View, Calif., seems like an anachronism--the last dot-com standing, if you will. Its lobby, save for the baby grand piano, calls to mind a kindergarten classroom. Shoot the Moon games lie on the coffee tables. The lunchroom serves free food prepared by the former chef of the Grateful Dead. Friday meetings resemble get-togethers at summer camp, right down to the roll-up projection screen the company uses to show movies.

But to understand what's behind Google's success, one needs to travel ten miles south to its data center in Santa Clara. Here, in three over-air-conditioned cages, each the size of a small office, are thousands of Google's servers. There are more than 10,000 such servers in five of these data centers around the country. Many of the machines look as if high school students had built them for a science fair. They have no cases but instead slide out of their racks on kitchen-drawer rails.

It's cute, yes. But it also helps explain why Google still exists and why Schmidt went to work there: Each rack has 80 servers, instead of the typical ten, which means that Google can get eight times the firepower that competitors can in the same space. The servers run the free Linux operating system, not the expensive Microsoft or Sun OS. And because the computers are built in-house with commodity hardware, they can be repaired or replaced easily.

It's hard to overstate the flexibility the setup has given Google. Everyone goes ga-ga over Google's search software. And it is an important reason for the company's success. In effect, it ranks Web pages not by how many times keywords appear, which is what most search engines do, but by how popular and relevant each page is.

Conceptually that sounds easy to duplicate; technically it is mind-numbingly complex and remains a huge barrier to competitors. The program was the basis of co-founders Sergey Brin's and Larry Page's Ph.D. work at Stanford University before they dropped out in 1998 to start Google. But what kept the company in business long enough to let its software catch on was its low-cost infrastructure.

It used to cost an arm and a leg to build and run a network like Google's: Linux didn't exist, and the price of computer parts and bandwidth, which Google consumes like a phone company, was high. The founders' genius was recognizing that a network could be built with off-the-shelf parts, something others thought impossible. To get the company off the ground, Brin and Page raised $1 million from family and friends at the end of 1998, $25 million from Kleiner Perkins and Sequoia Capital six months later, and another $10 million from Yahoo in 2000. They haven't needed another cent.

Okay, we know how the company saves money. But how does it make money? By selling its search technology to companies like Yahoo, AOL, and the Washington Post so that they can incorporate Google searches in their Websites. And it sells online advertising. That is the part of Google's business that's caused the most skepticism. Why? Because of the perception that online advertising doesn't work very well. And until Google and rival Overture started doing it, there was a lot of truth to that. But the two companies discovered that it was the way online advertising was sold and displayed, not the concept, that was the source of advertiser dissatisfaction.

Overture and then Google started selling something called sponsored links, which is a fancy name for a classified ad with an Internet link. Sponsored links cost nothing to produce, load easily through a narrowband connection, and make a more subtle pitch than banner ads. They're also more popular with advertisers, which pay based on how many times people actually click on the ad. With banners, advertisers have to pay based on how many times the ads were displayed, which gives no indication of how the ad is doing. Google took the model a step further, marrying the text-based ads with its search results, something Overture did not have. In other words, if you do a search on Google for, say, Botox, an ad and link for Laserlightrx.com comes up alongside your search results. The upshot was something that Website operators had been trying to accomplish since the beginning of the Internet: meaningful search results accompanied by relevant advertising.

With Schmidt at the helm, Google is aggressively trying to leverage its reach, technology, and advertiser base. It already sells its search services to 130 companies and governments; now it is allowing software developers to incorporate its technology into their applications. In February it started selling a search "appliance"--a computer case with Google's hardware and software inside--to help companies search their own Intranets. In hopes of starting a referral business, it has scanned thousands of catalogs so that people looking to buy anything from Cuisinarts to scalpels can locate what they want. The ultimate goal? "To enable you to find anything you are looking for anywhere," Schmidt says.

Many things could still derail Google's plans. A big challenge will be to keep the company's wacky culture intact while growing the business. To outsiders, that may sound like a waste of time, but because of his 14 years at Sun, Schmidt knows that a business culture like Google's plays a key role. One of Google's strengths is its brainy team--15% of its employees are Ph.D.s, and the staff is encouraged to come up with ideas and run with them. People like that don't work well in a militaristic corporate hierarchy. To that end, Schmidt has taken great pains not to push founders Brin and Page aside, but instead to make them visible at his own expense.

The AOL deal exposed changes that will be necessary as Google grows. Brin and Page hate keeping secrets from their staff. At Google's end-of-the-week meetings, for example, they freely share things like financial results. But no business can be completely truthful and open with employees all the time. When negotiations with AOL were at a sensitive point, the staff knew something was up and asked Brin about it. His answer was truthful on its face, but misleading.

Another daunting issue is how Google will deal with companies or organizations that object to search results that may violate copyright laws. When the Church of Scientology complained about a Website called Xenu.net, Google acceded to its demands, but Schmidt says he doesn't know what he will do if this happens a lot.

The one thing Schmidt says Google doesn't need now is an IPO. It would obviously be the most sought-after tech deal in a long time, and eventually it will become a necessity because Google's investors want to cash out, and the company needs money to expand. But as Schmidt points out, "We don't even have a CFO. You'd think we'd want to get one of those before we did something like that, right?" Hey, how about doing a search on unemployed CFOs?

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