Declining operating margins at Google? No cause for alarm

I starting thinking about Google’s sources of revenue tonight, specifically their AdSense program, and decided to do a little research. What got me interested was understanding how their AdSense program, which pays content providers when a user clicks on a Google-provided text ad on their site, relates to their bottom line.

Logically, the Google’s AdSense for Content program seems like a money machine for Google. The idea is fairly simple, advertisers go to Google and bid on a keyword or term using their AdWords platform. The advertiser can choose whether to advertise only on Google sites or whether to advertise on Google sites and within the Google Network. The Google Network consists of thousands, probably millions, of content providers like myself that create web pages, write blogs, post videos, sell products, etc online. If you, as an advertiser, agree to advertise within the Google Network, its likely your ad will show up on a non-Google site. The beauty of AdWords is that you generally only pay per click (you only pay if someone actually clicks on your ad and goes to your site), and your ad will generally only show up on pages with relevant content. If you sell horse shoes for a living and advertise on AdWords for your horse shoe business, its likely your ad will only come up on partner sites where the bulk of the partner content is related to equestrian subjects. If someone clicks the ad, you pay Google a predetermined amount (AdWords is an auction system that allows you to bid on certain search terms that apply to your business), Google passes the bulk of that amount on to the content provider (the person to created the horse shoe related web site), and they keep a small amount for themselves.

So, big deal you may say, Google is sharing, they say the bulk of, their ad revenue for that click with the content provider… that doesn’t sound too profitable.

However, you have to think harder about the situation. Google, according to their latest 10-Q quarterly statement, earned 99% of their revenue through advertising. About 60% of Google’s ad revenue came from Google web sites, the other 40%?…The Google Network. Thats right, 40% of all the money they brought in last quarter was brought in through collecting a small portion of the advertising fee that the advertiser paid when someone clicked a Google AdWord ad on a non-Google site. This is pretty huge. This basically says Google’s leading position in the search industry could disappear, effectively www.google.com could disappear, and the company would still bring in 40% of what they are making today by having other people display ads on their own sites. Millions of people are adding content to the web daily and Google is placing content-relevant ads on those sites through AdSense, bringing incredible value to their advertisers, a source of revenue to the web site creators, and still having enough left over to line their pockets.

The reason I bring all this up, and the reason for the title of the article “Declining operating margins at Google? No cause for alarm” is because of the way they recognize this extremely significant source of revenue. According to their quarterly statement, all revenue brought in by selling ads on Google Network sites is considered revenue. If you pay a nickel to Google for someone to click on your horse shoe shop ad, Google will record that nickel as standard revenue on their income statement. The four cents (or whatever the rate is, it isn’t too important) that they pay the content creator who wrote the page about horses is counted as Traffic Aquisition Costs and rolled up under cost of revenues. This makes sense, but it heavily impacts operating margins. Operating margins basically say what percentage of each dollar of revenue was profit. Using the example I talked about before, Google may charge the horse shoe company $0.05 every time someone clicks their horse shoe shop ad on a Google Network site, Google may give $0.04 of that to the person who runs the website that brought in the click. Google will keep perhaps $0.01. How does this accounting method affect the operating margin? Well, Google says the $0.05 that it got from the advertiser is revenue and the $0.04 is a Traffic Aquisition Cost (an expense, a cost of revenue) meaning the operating margin in this case is 20%. Of the $0.05 they brought in in revenue, only 1/5 made it down to the bottom line as profit.

The operating margin for ads on the Google-owned websites is much higher as they don’t have to pay the $0.04 to the content provider, as they are the content provider. Nearly all of that nickel is pure profit for them.

Either way, if operating margins decrease at Google over the coming quarters due to this reason, I wouldn’t be disappointed. Normally, decreasing operating margins at a company are a bad sign as it means it is costing them more money (usually in the form of higher costs or more personnel) to bring in the same amount of money. This isn’t quite the case at Google. If operating margins decrease, it doesn’t mean it is costing them more money in true form, it just means a larger mix of their revenue is coming from the advertising services on the Google Network where a large percentage of the revenue is given to the content provider. It doesn’t mean revenue has dropped (that would be a bad sign), it just means that they are likely selling more ads on Google Network sites as a mix of their product. Given that there are millions of people who are doing all the work for Google in regards to providing rich, content relevant information on their own sites. As a shareholder of Google I’d be perfectly content if Google continued to increase their ad revenue from Google Network sites at the cost of having lower operating margins as long is it is due to this reason.

Getting someone else to do all the work while you take a portion of the profits? Sounds like a pretty sound strategy to me!

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