Google Growth Needs Organic Diet: Ad Growth May Be Slowing Deceptively Fast

Last Updated Aug 11, 2008 2:30 PM EDT

google-logo.jpgErick Schonfeld on TechCrunch wrote an interesting analysis of Google's growth. The core of his analysis is an examination of organic growth, or the increase in revenue from Google's own pre-existing activities and not acquisitions. What I found interesting was taking his analysis and looking at where Google's revenue originates, because the combination says even more about what might be happening within the company.

Taking some figures on Google's organic growth rate estimates from Citi analyst Mark Mahaney and comparing them to Google's own reported revenue increases, Schonfeld finds the following:

In the third quarter of last year, both growth rates were the same: 57 percent. By the second quarter of 2008, Google's total revenue growth rate had settled down to 39 percent, but its estimated organic growth rate was significantly lower, at 32 percent.What this suggests is that Google's core search advertising business may be decelerating faster than a glance at Google's quarterly income statements would indicate.
I think there's another dynamic at work as well. Google acknowledged in its 2007 annual report that downward pressure on margins is a business risk. The margins the company sees from ads on the Google Network are "significantly less" than the margins it sees from advertising on its own sites.

Google's own Web sites have represented a growing percentage of its total ad revenue, from 56 percent in 2005 to 65 percent in 2007. Over the same period, revenues went from $6.14 billion to $16.59 billion, and net income went from $1.47 billion to $4.20 billion.

In other words, the ratio of net income to revenue has jumped from about 23.9 percent to 25.3 percent. The only thing pushing this ratio up is Google's increasing dependence on ad growth at its own sites.

A few calculations show that Google's revenue from its network was $2.82 billion in 2005, and in 2007 it was $5.81 billion. Total revenue growth over the period was 270 percent, but growth in Google Network revenue lagged at about 206 percent.

Google may be intentionally growing its own site revenues at the expense of expanding the Google Network, simply to keep its margins up. Growth will continue to come mostly from acquisition, because the company needs to expand its holdings on the Internet to continue supporting higher margin revenue. That could well explain why Google seemed to favor in search results entries from its new Wikipedia-competing, user-written reference site Knol rather than more established pages.

As the approach becomes more obvious in the market, it could backfire. To favor its own sites over those of business partners is to commit the classic error of going into competition with customers. It often winds up badly -- particularly when one of your three key commitments is:

We will do our best to provide the most relevant and useful search results possible, independent of financial incentives. Our search results will be objective and we will not accept payment for inclusion or ranking in them.
Directing revenue to your own sites isn't any different.
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    Erik Sherman is a widely published writer and editor who also does select ghosting and corporate work. The views expressed in this column belong to Sherman and do not represent the views of CBS Interactive. Follow him on Twitter at @ErikSherman or on Facebook.