Google's Ad Revenue Mystery: Five Possible Theories

(Bloomberg) -- Shares of Google’s Alphabet Inc. shares fell off a cliff on Tuesday after the company’s first quarter earnings report, the sharpest drop in seven years. One culprit was the unexpected shortfall in Google’s main business: Advertising sales grew at the lowest rate since 2015.

Another culprit: Google management offered no clear reason why.

Analyst questions for more detail on the earnings call went unanswered. Brian White from Monness Crespi Hardt, accused Google of following a “botched” quarter with a call “littered with evasive commentary" in a research note. “In the words of Winston Churchill, we found the call ‘a riddle, wrapped in a mystery, inside an enigma’ given the company’s inability to satisfactorily answer even the most basic of queries," White wrote.

During the call, Google’s Chief Financial Officer Ruth Porat blamed currency fluctuations and the timing of "product changes" that were necessary for long-term performance. Neither she nor Google boss Sundar Pichai gave details about what those changes were. A Google spokeswoman declined to comment.

In that information vacuum, theories are proliferating. Here’s a run-down of what could have gone wrong for Google’s ad business.

Your phone screen is already full of ads

Some observers worry that Google is running out of space to cram in ads. In recent years, the company has loaded mobile search results with paid promotions. Sometimes a phone screen is nearly all ads after a search.

“Growth in search revenues over the past several years has been driven by filling the page with more & more paid links,” Bill Gurley, a venture capitalist with Benchmark, wrote on Twitter. "There is no more room for this mechanism to drive growth."

For years, analysts have fretted that Google would max out search ads. Up to now at least, Google has always proven them wrong.

YouTube made changes to how ads are displayed

One key metric Google does share -- the number of times a Google ad is tapped, or "paid clicks" -- slowed to its lowest growth rate in years. Porat gave investors one explanation: People weren’t clicking on as many YouTube ads as they were last year. That slowdown came from some "changes that we made in early 2018," Porat said.

It was a confusing statement since the executive didn’t say what those changes were. One theory pinpoints a suite of new tools Google launched about a year ago for targeting people who watch YouTube. Those were designed to lure more "direct response" ads -- promotions from marketers aiming for a specific action, like a purchase, rather than just billboard branding -- and let advertisers target consumers based on their searches, locations, web browsing and videos watched. Those ads may have debuted well last year, setting a difficult-to-reach bar for this quarter.

That’s the rationale that Bank of America Merrill Lynch’s Justin Post went with in a note on Tuesday. “We think (but can’t confirm)," he wrote.

The YouTube clean-up is proving costly

YouTube’s custodial work may have contributed, too. Last year, YouTube made myriad attempts to remove vile videos from its platform and shield them from advertisers, who have staged several boycotts of the service. YouTube yanked thousands of ads. Fewer ads mean fewer clicks. Those changes may have taken some time to implement, resulting in the drop during the first quarter.

YouTube’s also been making some changes to how it recommends videos. Certain videos that are blatantly false or harmful aren’t suggested to users, the company said. Pichai told investors that YouTube would be taking further steps to curb this problem.

“We believe the majority of the deceleration was self-imposed,” said Ronald Josey, an analyst with JMP Securities. Google makes many changes each quarter, and not all of them work out, Josey said. “We point to changes at YouTube’s recommendation engine as an example.”

Apple is making it harder to track ads on Safari

Starting in 2017, Apple Inc. brought the hammer down on ad tracking. The iPhone maker restricted certain tools companies use to track websites consumers visit on its Safari browser. The privacy effort, called Intelligent Tracking Prevention, revamped again in March, adding further restrictions on tracking.

Google runs a massive exchange for advertisers to sell and buy ads that run on browsers like Safari. Some companies in this industry have been pummeled by Apple’s changes.

Many publishers saw sales from these ad tracking tools on Safari drop by more than half since the fourth quarter, said Ari Paparo, chief executive officer of advertising firm Beeswax. "It had a pretty striking effect on anyone who uses cookies," he said. Google, he added, "wouldn’t be immune." As with mobile search and YouTube, Google doesn’t disclose sales for its automated display ad business.

Amazon is becoming a tougher competitor

The e-commerce giant has been building an advertising business of its own, and it’s set up to compete squarely with Google. Amazon has excellent data on what people want to buy, and its been aggressively trying to get advertisers to use it for shopping ads, which are traditionally a major source of revenue for Google.

Amazon’s digital advertising franchise has grown into the third largest in the U.S., trailing only Google and Facebook, research firm EMarketer estimates. First-quarter sales in Amazon’s “other” segment, which is mostly advertising, increased 34 percent to $2.72 billion, the online retailer said last week.

That’s still small compared to Google’s business, but barring a jump in the overall size of the advertising market, that rate of growth is going to start eating into someone’s revenue sooner or later.

©2019 Bloomberg L.P.