Behind a One-Day Gain the Size of Xiaomi: Google's Step-by-Step Retreat Toward Wall Street

"Google is not a conventional company. We do not intend to become one." — Larry Page and Sergey Brin, 2004

This morning, Google's stock took off like a rocket.

Counting after-hours trading, Google's shares rose more than 14% in under 12 hours, adding more than US$45.5 billion in market value — more than Xiaomi's latest valuation.

The trigger was the latest quarterly earnings report. From April to June this year, Google's revenue grew 11% year on year to US$17.73 billion, and profit grew 18% to US$3.93 billion. For a company of Google's size, double-digit growth is remarkable.

Unlike in the past, though, the profit growth did not come only from higher revenue. It also came from spending cuts.

"Part of the decline in expenses came from more discipline in managing spending. Legal expenses were also lower than last year," Ruth Porat, who became Google's CFO only in May, told analysts on the earnings call after the report came out.

"Discipline" is a word that has come up again and again in the last two quarterly reports. When Google's CFO talks about more disciplined spending, it means projects inside the company are no longer as free as they were. The clearest example: over the past 3 quarters, Google's hiring has fallen quarter after quarter, the first time this has happened since the financial crisis.

According to a Wall Street Journal report earlier this month, a Google team that wants to hire must now submit a plan explaining how the extra people will help it reach business goals such as revenue and user numbers.

For years, Google's teams enjoyed a freedom that traditional rivals like Microsoft and Cisco could hardly match: every team assumed it could bring in new people each year. Beyond hiring, approvals for business travel and for attending events have also grown stricter.

At other companies, these would be entirely routine procedures. Cutting spending to raise profit margins, and beating Wall Street analysts' expectations every quarter, is what most public companies do.

But Google is not most companies. It once declared that it was not a conventional company and would not become one, and its IPO was seen as the fast-rising tech industry's challenge to Wall Street. Only in the past 4 years has it started to look more and more conventional.

"Google is not a conventional company. We do not intend to become one."

This was the first sentence of the letter that Google's two founders, Larry Page and Sergey Brin, wrote to investors when the company went public in 2004.

From the start, the two founders never meant to play by the usual rules. At the time, it was rare for tech founders to write directly to investors. But after Google did it, the letter became standard practice for tech IPOs; when another tech giant, Facebook, went public in 2012, its founder Mark Zuckerberg also wrote one.

The point was not the letter itself, but that Google was telling Wall Street to listen to it.

In the letter, Google said plainly that it would not adjust how it ran the business to suit investors' reactions after each quarterly report, and that it would spend money on imaginative long-term projects — even though such projects often cannot promise a clear rate of return at the outset, and make the financial statements look bad.

"In technology, change usually happens suddenly rather than gradually," Page wrote in the foreword to How Google Works, by former Google CEO Eric Schmidt and Jonathan Rosenberg. "Incrementalism will make Google gradually irrelevant."

To keep short-sighted outside shareholders from interfering with Google's long-range vision each time a quarterly report came out, Google split its stock into two classes: one carrying ten votes per share, all held by the management team of the time, and another carrying one vote per share, open to other investors.

The letter said bluntly that this was the only way to keep the founders in control after the listing. The two founders and then-CEO Schmidt together held 37.6% of the votes, and Google's management and directors as a whole controlled 61.4%. In other words, outside money could earn financial returns after the IPO, but had no say in how the business was run.

Google's initial public offering in August 2004 was in fact a rather shaky affair.

Page and Brin often met suit-clad investors in casual clothes. Their answers to questions tended to leap from thought to thought, or offered little substance, which frustrated investors.

A week before the offering, the two gave an interview to Playboy, discussing many business topics. The issue carrying the interview came out only after the offering was announced, which led securities regulators to open an investigation.

After a bumpy 4 months, Google raised US$1.67 billion in its IPO and, with a market value of US$23 billion, became the largest tech company ever to go public at that time.

After the listing, Google's innovative search advertising business took off. Google spent US$3.1 billion on the ad-tech company DoubleClick, which paved the way for its business model of selling search ads.

By the end of 2007, Google's share price had reached US$350, up nearly 3.5 times in four years.

Backed by plentiful capital, Google's habit of casting a wide net and keeping little control over what it spent paid off handsomely.

Android, Gmail, Maps, YouTube... each of these products now reaches a billion users, yet none was a star in the eyes of outsiders at first.

It seemed Google could stop caring what Wall Street thought. That lasted until 2011.

The change began in 2011

In January 2011, Eric Schmidt — brought in ten years earlier to serve as CEO alongside the two founders — handed Page his resignation letter.

This was the first major turning point since Google's IPO. On the reason for the change at the top, Schmidt was very blunt: "I knew what I should do, but I didn't seize the opportunity. The CEO should be responsible for the company, and I screwed it up."

What Schmidt screwed up was social. Facebook, the social network that Harvard dropout Zuckerberg founded the year Google went public, took only 6 years to reach 500 million users. On the day of its IPO in 2012, Facebook was worth US$104 billion, the highest market value of any newly listed company in history — a record that stood until Alibaba's listing in 2014.

Google, meanwhile, after failing to buy the social network Friendster in 2003, had for a time ignored the rise of social networking. By the time Schmidt saw the threat from Facebook, Google launched 3 social networks around 2010 to fight back. But its efforts were scattered, and all three products failed quickly.

After Schmidt stepped down, Page became CEO and threw all of Google's resources behind Google+. After 4 years of struggle, Google+ was broken up early this year, a tacit admission of failure. In fact, since last year Google+ had no longer been allowed to hire.

While fighting Facebook, Page launched "Spring Cleaning" in 2011, shutting down large numbers of ongoing projects. "Spring Cleaning" then came around in every season, and in 2012 alone 24 projects were cleared out.

You could say Google began to focus. It disposed of many small projects that had little to do with its main business and limited potential, and concentrated on projects with more market appeal. Some of what it cut were products nobody used, but the cuts also included Google Reader, which many users loved.

At the same time, "20% time," the policy of free exploration for employees that Google was so proud of, came to exist in name only.

"We encourage our employees, in addition to their regular projects, to spend 20% of their time working on what they think will most benefit Google. This empowers them to be more creative and innovative." Google's letter to investors at its IPO held up 20% time as proof that the company valued the long term.

In 2013, a report by the business news site Quartz described how 20% time had changed: engineers needed a manager's approval for 20% projects; performance reviews had multiplied, and 20% time did nothing to help engineers meet their regular targets.

The original 20% time had become the extra slice on top of a 120% workload. It meant Google no longer encouraged employees so firmly to take risks in pursuit of big rewards.

In its place came the Google X lab, overseen directly by Brin. Google X focuses on new technologies that could be put to use within about a decade; it has produced the Project Loon balloon project, self-driving cars, and a reworked Google Glass.

Innovation from everyone gave way to innovation centralized under the founders.

A new year that began with spending cuts

Google's spending changes became noticeable at the start of this year. Patrick Pichette, Google's previous CFO, had already brought up "discipline" in project investment again and again on earnings calls early this year.

After Pichette announced in March that he was leaving to spend time with his family, Google hired Ruth Porat away from Wall Street, where she had been CFO of Morgan Stanley for five years. Porat, who spent 28 years on Wall Street, once led a team advising the US government on strategy after the financial crisis. She was also reportedly once a candidate for deputy secretary of the Treasury in the Obama administration.

Porat is paid like a star, too. On top of a US$650,000 base salary, she gets a signing bonus and a large equity grant, and will receive US$30-40 million in her first year at Google — a sharp rise from the US$8-11.7 million a year she earned on Wall Street.

Financial analysts broadly welcomed her arrival. "Google has found the right person," a senior Wall Street analyst told the Wall Street Journal. When news of the spending cuts came out, Google's stock rose.

Their confidence in Porat may be justified.

"We have always focused on finding new opportunities across our many businesses," Porat said on the earnings call held in the early hours of today. "To that end, we allocate resources carefully."

Porat's careful budgeting showed up first in hiring. In the second quarter, Google added 1,700 employees, more than 100 fewer than the quarter before. Last year, by comparison, it added an average of 2,435 per quarter.

New positions added at Google each quarter since its IPO; chart from Quartz

This is the first time since the financial crisis that Google has cut the number of new positions for 3 quarters in a row.

According to the earlier Wall Street Journal report, hiring for new projects inside Google now requires an application to management. The application must spell out how the project relates to Google's main business and what commercial return it is expected to bring, and then wait for central approval.

In the past, hiring for new projects was taken for granted. Keeping up that pace of hiring let Google keep attracting the best people in every field.

In the end, it comes down to finding the next source of growth

Google has begun to give ground to Wall Street step by step, abandoning its old way of spending money without regard to short-term results.

That compromise came mainly because Google has not managed to find a source of profit to follow desktop search advertising.

When Google went public in 2004, its business was essentially one very popular search engine. Gmail had just launched, and YouTube did not yet exist.

Today, Google's products go far beyond what it had ten years ago. Apart from the special case of China, its grip on search has not weakened one bit. Android, which Google bought, has grown into the world's largest operating system, running on 1 billion mobile devices, and YouTube has become the world's largest video community, with more than 1 billion users.

But one thing has not changed: the vast majority of Google's revenue still comes from search advertising, above all desktop search advertising, and that business is nearing the limit of its growth.

As Asymco has pointed out, there is a clear causal link between the number of internet users and the growth of Google's revenue. In the world's developed regions, the share of people online is already very high, while ad revenue in less developed regions is growing extremely slowly.

So once more than half the people on earth (not counting China) are using Google's search engine, there is little room left for Google to find new users. Add falling prices per click, and Google could hit a turning point in revenue growth as early as next year.

Growth of internet users worldwide outside China (blue) compared with Google's revenue growth (red)

The rise of smartphones and social networks is another blow to traditional search engines. In mobile advertising, a fast-growing market, Facebook has gathered vast amounts of user data and its share is climbing fast. On their phones, people spend far less time on search engines than on social networks, so making money will get harder and harder for Google.

When people talk about Google, they mostly talk about forward-looking projects such as smart glasses and self-driving cars.

But how much revenue will those bring Google in the next few years? Former Google CFO Pichette said in an earlier interview: "I don't need to spend much time on these experimental projects — worrying about a self-driving car, for example."

In 2011, Schmidt named Google, Apple, Amazon and Facebook as the 4 most influential tech giants in the world:

Share prices of Google, Apple, Amazon and Facebook over the past year

The past year's share prices make it plain that, of the four internet giants, Google is the only one struggling to win over investors. In fact, without the spending cuts and the revenue growth at YouTube, Google's share price would now be more than ten percentage points below where it began the year.

Eight years after launching the iPhone, Apple is still growing at a furious double-digit pace and has become the world's most valuable company.

Amazon botched its phone, yet quickly won back the market's trust with the stunning performance of its AWS cloud business, and has grown faster on thin profits a few tens of times smaller than Google's.

The only good product news in Google's report is that YouTube usage was 60% higher than a year earlier, bringing in a lot of ad revenue. YouTube is now essentially the only Google product suited to carrying ads on mobile phones.

Mobile ad market share: Facebook's has quadrupled in two years

Meanwhile, according to survey figures released by Adobe, more and more advertisers prefer to place video ads on Facebook and Instagram rather than on Google Search and YouTube. Across the mobile ad market as a whole, the gap between Facebook's share and Google's is also narrowing.

Google is without doubt a great company. Through its search engine it made information available to everyone and changed our daily lives completely. But unless it can change the outlook for mobile advertising or find other sources of revenue, "conventional" is what we will see more and more of in Google.

Cover image from WashingtonPost