Google Vulnerable to Shrinking Ad Dollar

SAN FRANCISCO -- Google's ( GOOG) tough resilience in the face of economic turmoil may soon be a thing of the past.

The company will post its third-quarter earnings after the close, and while no one expects it to flop, there is less chance of it coming out unscathed the way it always has, to the envy of other Internet companies such as Yahoo! ( YHOO) and eBay ( EBAY).

In keeping with regular practice -- one that has frustrated many analysts -- Google has not provided any guidance on its results. But Wall Street predicts it will earn $4.80 a share on revenue of $4.05 billion.

Online advertising in general has been feeling pressure from advertisers pulling back on their spending in a down economy. Search ads -- where Google dominates and makes the bulk of its money -- have escaped most of the pain, since they typically generate a high return on investment.

But some analysts see advertisers cutting back on the dollar amount they are willing to pay for the search ads, and that could affect Google's revenue.

Jeffrey Lindsay, an analyst for Sanford Bernstein, expects paid-search conversion rates to fall, writing in his research that "even if people are clicking the ads, we think fewer of them are actually buying the goods and services, which reduces the advertiser's ROI."

Lindsay reduced his revenue growth projections for online advertising as a whole to 17% this year from his previous forecast of 20%. He also lowered his compound annual growth rate through 2012 to 12% from his earlier prediction of 15%.

"We are not making any specific market share or performance-based reductions for Google -- our reduced estimates are due entirely to the weakening macro-environment and its knock-on effect on advertising overall and dollar appreciation," he wrote.

Doug Anmuth, an analyst for Barclays, raised questions about some of Google's smaller advertisers who may be struggling in light of the current credit crisis.

"We have increased concerns about the long-tail of Google's advertiser base, those small businesses and mom-and-pops who have ramped up their search spending over the last couple of years but now may be allocating less or no money to advertising or may even be having trouble paying the bills," he wrote in his research. "We note that Google's bad debt expense increased from $14 million in the first half of 2007 to $51 million in the first half of 2008."

In past quarters, Google has shown confidence in its ability to withstand macro-economic troubles, but it recently started to acknowledge the possible impact.

In an earnings conference call with analysts in July, CEO Eric Schmidt introduced the company's chief economist Hal Varian for the first time to address concerns over the economy. Many on Wall Street took that as a sign that Google might not be a resilient as once thought.

Revenue grew by only 3% sequentially in the second quarter, and the company missed Wall Street earnings estimates; that sent the stock down nearly 10% the next day. It has yet to recover.

An onslaught of cautious analysts' reports has also hurt the stock in recent days, on top of the constant beating the overall market has been taking as a result of the financial sector meltdown. Google shares have fallen 54% from their 52-week high.

Anmuth maintained that Google is undervalued at its current levels. He also noted that "when we look across the rest of the advertising space, we think Google will hold up better than any other name due to its success-based nature and high ROI."

Nonetheless, Anmuth argued for more transparency from Google, especially given the current climate. Although the Internet giant has gotten away with offering scant details about its operations in the past, he called for it to change course, noting that as Google's growth decelerates, investors will no longer see it as a top-line story and will want to know more about the bottom line.

"Google's general lack of transparency and policy not to issue forward guidance was not as much of a concern during its first few years as a public company during its hyper-growth period," he wrote.

"However, with great macro caution, a more highly penetrated business model, and potential foreign exchange headwinds, we think investors need more clarity during this less certain period."