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Last year's question of whether Google might be invulnerable to a recession has officially been answered. Since the beginning of the year, investors have sliced the company's stock price nearly in half over fears that spending on online ads will slow or fall as the credit crunch freezes wallets.
But there's an upside for Google (nasdaq: GOOG - news - people ): Even as the search giant suffers, the company's competitors seem to be suffering more. And by the time the economy has recovered, analysts watching the search market say the downturn may have only helped Google tighten its already dominant lead in search marketing, the largest--and still growing--category of the Web ads.
On Tuesday, Yahoo!'s (nasdaq: YHOO - news - people ) unhappy earnings announcements drew a sharp contrast with Google's relatively positive results the week before. Even though Google's revenue fell a bit short of analysts' expectations, the search engine giant reported an earnings gain of 26%, to $1.4 billion for the quarter. (See "Google Hits On The Bottom Line, Not On Top.")
By contrast, Yahoo! said Tuesday that third-quarter earnings fell 64%, to $54 million, on revenues of $1.79 billion, and that the wounded company would lay off 1,500 employees. (See "Yahoo! Earnings Plunge, Cuts 1,500 Jobs.")
In fact, Google's good news in bad times may be based in a bigger trend. Overall, online advertising spending numbers are looking sickly. According to numbers released earlier this month from the Internet Advertising Bureau, spending fell in both the first and second quarters of the year. That marks the first time that either first or second quarter spending has dropped with respect to the previous quarter since 2003.
But search advertising--the small text ads placed beside search results--show signs of relative health. Those pay-per-click ads accounted for 44% of online ad spending in the first half of 2008, up 3% from the first half of last year, while spending on banner ads stayed flat at around 21% of the total.
Advertisers' migration toward search advertising is partly a result of belt-tightening companies looking for a more measurable and accountable form of marketing, says Greg Sterling, a search market analyst with Sterling Market Research. While companies are typically charged a certain sum every time a display appears, a search ad only costs an advertiser when it's clicked.
That difference, Sterling says, has created "the perception that search ads are a safer bet than display advertising," he says. As the downturn squeezes ad spending further, Sterling says that stingy companies will continue to give an added boost to search marketing, a category where Google receives around 71% of all spending, according to ad-tracking firm eMarketer.
Yahoo!, AOL and Microsoft (nasdaq: MSFT - news - people ), all of which are more invested in other forms of online advertising, will suffer from the perception of search ads as the thriftiest form of marketing, says Sterling. "If Google were as built up in display advertising as in search, it would see similar weakness," he says. "But that's the irony: [Google's] business is less diversified, so it will benefit from the relative strength of the one sector it dominates."
To be sure, the move toward search ads isn't strictly new, argues eMarketer analyst David Hallerman--the trickle of advertising funds from banner ads to pay-per-click search ads has been a slow process, he says. But this year's numbers show an acceleration: The fraction of spending on search advertising jumped three percentage points in the first half of 2008, compared to just one percentage point in 2007, according to the IAB's numbers.
"A recession that lasts a few years may incrementally boost a trend that's been ongoing regardless," Hallerman says.
While the downturn chokes spending for Google's major competitors, it may also cut off funding for potential foes in their embryo stages. One potential upstart competitor, Wikia Search, may already be feeling the crunch: Its parent company, Wikia, announced this week that it will lay off 10% of staff. More generally, the credit crisis has made IPOs all but impossible for small start-ups and has chilled venture capitalists' enthusiasm for young potential Google-killers.
In this market, the most likely outcome for any successful search start-up is being bought, likely by Google itself, says Gartner Research analyst Andrew Frank. "Some innovative start-up could have an impact on the market if they achieve a real breakthrough," he says. "But the most likely exit strategy is acquisition. The downturn has reduced speculative market caps and created real bargains for companies like Google with cash on hand."
The increasing invincibility of Google's search advertising dominance hasn't gone unnoticed by anti-trust authorities. In July, the Senate Judiciary Committee held a hearing to discuss the anti-competitive implications of Google's proposed partnership with Yahoo!, which would allow the struggling Web portal to host some fraction of Google's ads. Following that hearing, the two search competitors have put their partnership on hold, likely sensing the government's wariness of the deal's perceived impact on advertising prices.
As the economic downturn exacerbates the troubles of Google's competitors and solidifies its grasp of the search advertising market, Google's biggest barrier may become government intervention. "The dilemma for Google now is how it will continue to grow," says Greg Sterling. "It may benefit from the weakness of its competitors, but it will have to avoid incurring the wrath of the Justice Department."
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