Google's Got Good Reason to Be Worried

The company may have to finally admit it's feeling the economy's sluggishness.
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SAN FRANCISCO --

Google's

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earnings miss last quarter raised suspicions that the Internet behemoth had finally been stung by the macro-economy.

While the company's first-quarter earnings report on Thursday may be the ultimate decider, it's looking increasingly as if those fears were justified.

In February, Google's stock plummeted nearly 9% the day after its fourth-quarter earnings fell short of Wall Street's expectations. At the time, many observers had speculated that larger economic pressures were taking a toll on the company -- something that Chief Executive Eric Schmidt had denied during a conference call with analysts.

The stock has yet to recover. In fact, Google hasn't been above the $500 mark since Feb. 22 -- a far cry from November, when the stock was soaring the $700 range and analysts were setting lofty price targets, some as high as $900. On Wednesday, Google shares closed at $455.03.

Now, following a series of monthly reports on the company's growth in "paid clicks" (the frequency of users clicking on an ad via Google's search results) the Street -- and investors -- have taken a more cautious tone. Analysts have revised both their price targets and first-quarter estimates, while investors brace for what the company's paid click data will mean for its first-quarter results.

As usual, the company hasn't provided any guidance. Analysts expect revenue of $3.61 billion excluding customer acquisition costs and earnings before items of $4.52 a share.

For investors, perhaps it's largely been the of a broad recession that's keeping some of them at bay. But it's harder to ignore the possibility that the economy is having a true impact on Google, through a combination of advertisers pulling back on spending and users clicking less frequently on ad-supported links.

The results from research firm comScore haven't helped. In January,

they showed that the company's U.S. paid clicks slipping slightly. That spurred another selloff in Google's shares.

For February, paid clicks picked up a bit, growing by 3% but still far from the 13% increase in December.

Late Tuesday, comScore showed that March clicks grew just 2.7%, resulting in total first-quarter growth of only 2%.

Google has been reporting its own paid clicks, but because it uses a different measure than comScore, the results don't match up. Nonetheless, they point to a downward trend. In the third quarter -- which is when the company first started including paid clicks in its results -- Google showed a 45% growth worldwide. The following quarter, however, paid-click growth slowed to 30%.

Some analysts maintain that this decline is by Google's own design. The company has been trying to eliminate fraudulent clicks, where advertisers purposely link to the ads of their competitors in order to jack up their rates. It has also been trying to minimize accidental clicks, or clicks that take users to sites they didn't intend to visit.

Jeffrey Lindsay, an analyst for Sanford Bernstein, further noted in recent research that Google is attempting to get rid of low-quality clicks, which result from Web site publishers trying to game the system by buying up low-cost keywords through Google's AdWords program and selling them to advertisers at a low price. Some have also been setting up sites that generate click traffic through Google's search function, then selling those results back to advertisers.

"We think Google has recalibrated its AdWords algorithm and is 'slapping' low-quality advertisers and arbitrage marketers off its search results pages," Lindsay wrote. "This is driving down paid clicks, which comScore is detecting, but it is also driving up keyword pricing, which comScore does not measure."

Lindsay said it's not clear exactly when Google will see the benefits of these changes.

"The key issue for investors is timing: Are the price improvements coming through fast enough to give a good first quarter, or will the pricing benefits lag the AdWords actions and only partially influence the results?," he said. "Either way, we think Google is positioning itself for strong future growth, and the recent pullback has opened up a good opportunity to buy the stock."

Google's Globe

In a March 20 note, analyst Ross Sandler of RBC Capital Markets said he's viewing Google's first quarter as light in the U.S., but strong internationally.

He pointed to comScore research that showed year-over-year U.S. e-commerce growth decelerating to 16% in the fourth quarter from 18% in the third quarter. It has slipped further still in the first quarter to 13%.

Sandler added that "given the weakening labor trends, high energy costs and waning consumer confidence, we believe further deceleration is possible in 2008. Internet and advertising executives, including Google, have recently echoed the 'we are not seeing any impact yet' rhetoric at public appearances when asked about trends in the U.S., but by the time weakness is acknowledged, it could be too late for investors."

Google's saving grace could be its exposure to international markets, Sandler said. He also maintained that search should hold up better than other sectors during an economic downturn because of its direct connection to users.

"However, we do not see meaningful positive catalysts playing out near-term," he said.

Google Long Term

In the long term, Sandler said he sees value in Google's

acquisition of online ad firm DoubleClick, which cleared its last regulatory hurdles last month. Google paid $3.2 billion for DoubleClick and recently acknowledged that it will eliminate some jobs as a result.

Sandler projected in his report that DoubleClick would add $80 million in revenue and $25 million in EBITDA, or earnings before interest, taxes, depreciation and amortization, per quarter this year, starting in Google's second quarter.

"Given Google's publisher and advertiser relationships in text based advertising, the company is extremely well positioned to leverage DoubleClick's data to do a better job of targeting relevant display ads for advertisers, and at the same time, pass on greater yield to publishers, than the competition," Sandler wrote. "We believe that Display could be the next meaningful business for Google, but won't 'move the needle' in terms of revenue until 2009/2010."

Google's report will be the latest in a string of tech heavyweights to report this week, following

Intel's

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on Tuesday and

IBM

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and

eBay

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on Wednesday.