Even Google Is Vulnerable

Its search business should survive an economic downturn, but its stock price likely won't.
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Is

Google

(GOOG) - Get Report

really recession-proof?

Investors are asking that question amid growing signs that the U.S. economy may be headed for a downturn.

The answer is complicated. Google's search advertising business is perhaps as insulated from a downturn as Internet companies can get. In fact, Google could even get a bump if the economy tightens. And given the growing overseas markets, the company may be even further protected.

At the same time, as Google bets its future on expanding into new markets, investors should realize the stock's price is more exposed to a slowdown than it has ever been.

It's no surprise that advertisers tend to cut back during downturns, but the type of search ads that make up almost all of Google's revenue tend to avoid a hit.

The reason is twofold: For one, advertisers pay for search ads only when users click on them. That gives these types of ads more accountability than some other forms of advertising, and makes advertisers reluctant to pull the plug even in downturns, says Kevin Lee, the executive chairman of Didit, a leading search-engine marketing company.

"Cutting back means they may be turning down acquiring sales and customers, so even when there is some belt-tightening, this type of ad spending is usually the last to go down," Lee says. "It could potentially even go up."

And unlike flashier ads that may help make new customers aware of their products or make a brand more appealing, search ads tend to be more closely linked to customers who are already likely to make a purchase -- and therefore drive sales.

"Our discussions with advertisers indicate that when marketing budgets get trimmed during periods of economic weakness, spending on media that drive sales gets cut last or not at all," Cowen analyst Jim Friedland wrote in a September research report.

Indeed, there is even reason to believe that Google could stand to benefit from a sluggish economy. As advertising budgets get lean, advertisers may rotate funds out of more expensive, difficult-to-measure and brand-building forms of advertising like television into more targeted efforts that can directly boost the bottom line.

Search advertising is a relatively new form of advertising and lacks history to draw upon. But Friedland draws a parallel between direct-mail advertising and search advertising, since both are designed with the intent of driving sales.

And he notes that advertisers have actually increased spending in every recession in the U.S. since 1950, and that the growth rate of direct-mail spending accelerated in five of the last nine recessions.

But Google, which should post close to $12 billion in revenue excluding costs this year, "is growing so quickly that it is unlikely that revenue growth would accelerate in an economic downturn," he says.

Google's growing exposure to international revenue could also help it during a recession in the U.S. During the third quarter, 48% of the company's revenue came from outside the U.S., compared to 44% for the same period a year ago.

Still, a downturn could hamper Google in its push into new markets. The company needs new markets to live up to Wall Street's lofty growth expectations. Even after a week-long drop of 14% to $641.67, shares currently trade at a price-over-earnings-to-growth ratio of 1.23, which means the company is expected to grow annual earnings by almost 35% for each of the next five years.

That sort of growth may seem easy for Google, given that net revenue grew 62% in its latest third quarter. However, that's down from 2006 when the company was posting year-over-year growth of more than 70%.

That means it will have to look well beyond the search ad market.

Two of the key markets that Google is hoping to storm into next -- the display ad market and the video market -- would be likely to feel the effects of a downturn more strongly than search. Google hopes to enter the display business through its proposed acquisition of DoubleClick and introduced video ads for its YouTube video-sharing service in August.

While more measurable than traditional media like television or newspapers, both forms nonetheless focus on the kind of brand-building that advertisers are quicker to pull back on in a downturn.

And unlike search, where Google is already a market leader, the company is only entering display ads and video now and faces an uphill battle. A slowing economy would only make entry more difficult.

The same goes for Google's ambitions in the mobile arena. The company's announcement of an operating system for mobile phones sparked excitement about the company's stock recently, and Google has frequently talked up the potential of mobile advertising.

But in the event of a downturn, "for Google's truly experimental new-media formats such as search ads on Google mobile search, marketers' willingness to experiment will decrease unless that advertising is sold on a performance basis," says Didit's Lee.

Google's bread-and-butter business will hold up just fine -- and may even thrive -- in a tighter economy. But the same can't be said for the company's stock price.