Google's profits under attack

If you look at why AdWords generates as much revenue for Google as it does, you can break it down into three separate aspects and analyze the threats to revenue and profitability.

I delivered a keynote presentation at WebSideStory's user conference two weeks ago in Santa Monica. One of my slides aroused a fair amount of interest so I thought it would be interesting to give the gist of it here (along with the picture I used). It's specially topical a day after Google's press day, since it's about Google's future prospects. I had a couple of other slides that touched on the future for Microsoft, too, which I'll cover in a separate posting.

Woman chasing profit sign

One of the key facts that people often forget about Google is that AdWords was a lucky break. No one had any idea how enormously successful it would be. The only thing the company's managers knew at the time they set out to create it in late 1999 was that Google desperately needed some way of monetizing search results so it wouldn't have to sign up with banner-ad company DoubleClick.

If you look at why AdWords now generates as much revenue for the company as it does, I think it's possible to break it down into three separate aspects. Once you've done that it becomes easier to analyze where Google's revenues and profitability are under threat, and what the company needs to do to move beyond its current revenue sources. The extent to which Google's current prosperity is under threat also becomes a lot clearer.

The base level is what AdWords was initially designed to do — generate revenues from search results. This revenue stream will continue to exist as long as Google remains the preferred search engine for millions of users. It's relatively secure, so long as Google continues to invest in maintaining its edge in search — and so long as no one else comes along with a breakthrough next-generation search technology, as Google itself once did. But I don't believe this revenue stream is as profitable as other observers seem to think, especially now that Microsoft has stepped up its investment to compete head-on for the same ad dollars. Sooner or later, competition will force Google and its search engine rivals to start squeezing down the cut that they charge for serving ads — while still having to fund huge R&D budgets out of those revenues.

The next slug of profitability comes from the way that AdWords opened up advertising to a new 'long tail' market of advertisers. These small business and home business advertisers have no scope to negotiate their AdWords pricing in the way that larger media buyers can. This I believe has been a hugely under-estimated source of profitability (one that was magnified when the AdSense program opened up to the 'long tail' of small website publishers). But it is just as vulnerable to competitive pressures as the previous category, once Yahoo!, MSN and others begin to focus in on this market (I don't believe they have so far — they've been too seduced by the glamor of chasing the less profitable but higher-spending large-account business first).

The most profitable element, however, I believe has been totally overlooked. It's quite simply that Google gained first-mover advantage in delivering online advertising as a service. First of all by building an online interface that meant advertisers could sign up and manage their keyword advertising in a completely automated, self-service interface. Then by adding an API so that advertisers could build their own internal software (or even use third-party products like WebSideStory's Bid) to automatically manage their ad spending. Yes folks, AdWords is an on-demand application — a first-of-its-kind. Since there was nothing else like it on the market, Google has been free to charge whatever it liked for the service. In fact, that 'price' remains one of the Google's most closely-guarded secrets. It's the difference between what advertisers pay and what publishers receive — both of whom are sworn to secrecy by Google's terms of service. But while I can't tell you what the price is, I can say with certainty that Google faces increasing competition here, too. It has lost its first mover advantage, and this element of its profitability is also destined to fall.

Google's challenge is to maintain growth in its revenues and profitability. So far, virtually all of that growth has come through organic expansion in search traffic and in the success of its first-mover play in advertising-as-a-service (especially in opening up a new long-tail market). But now it's seeing competition in all of these core categories, which will inevitably squeeze profits as well as restricting growth. Its best hope is to expand into new areas, preferably ones where it faces less competition. So that's what the company has been trying to do with all its innovation and beta-version experiments.

One way in which it can grow is by expanding its content footprint. This can work in two different aspects. First of all, it can find new content to search, and thus increase the number of search results pages that it serves ads onto. Gmail has been a successful vehicle for this, and may be part of the explanation for its own content taking a faster-growing slice of ad revenues than third-party sites. Secondly, it can acquire new forms of content pages on which to display ads. Google Maps is one example, Calendar another.

The other strategy it could follow is to aim to develop some other first-mover innovation that will be as lucrative as advertising-as-a-service. If I were a shareholder I think this is what I would be hoping for. But I'm not sure that Google, even if it is trying to do this, really has its heart in it. Its mission, after all, is to organize the world's information. So long as it can make money by serving contextual advertising alongside that information, why try and invent anything else? Well, if the company is happy with limiting itself to those ambitions, so be it. It's quite a big mission. But it's far from being the biggest opportunity out there, as I'll discuss in my next posting.