# Updated: Google Q3: When Good Simply Isn't Good Enough

In the 2007 postseason, Alex Rodriguez batted .267, had an on-base percentage of .353 and hit a home run.

In the third quarter of 2007, Google’s revenue jumped 57 percent for its first $3 billion quarter, pushed profit 46 percent higher to$3.38 a share and beat the Street’s estimates by 16 cents a share.

See where I’m going with this? Both are playing at the top of their game, yet both have disappointed a bit with their recent performances. But that disappointment has come because they’ve been average, and not spectacular, the way they’ve been in the
past.

In after-hours trading, Google’s (GOOG) stock fell 1 percent below its official Thursday close, despite notching higher right after the headlines hit. Investors who, having pushed the stock up 33 percent in the past two months to an all-time high of \$641, looked deeper into the numbers and didn’t like what they saw.

Specifically, they saw profit growth trailing significantly behind revenue growth. In other words, Google is making money hand over fist, but it’s spending money hand over fist (and using a slightly bigger fist to spend it). That pushes down margins. And Wall Street can get very upset over falling margins.

The traffic acquisition costs (or revenues shared with partners) fell to 29 percent of revenue in the third quarter, from 31 percent in the same quarter of 2006. But that wasn’t enough to offset a rise in operating costs across the board: R&D spending was 13 percent of sales, up from the year-ago 12 percent; sales and marketing was 9 percent vs. the earlier 8 percent; and administrative costs were 8 percent vs. 7 percent.

All told, operating income was 31 percent of revenue, down from 35 percent a year earlier. Last quarter, Google said it was aware of rising hiring costs, but investors who were expecting immediate action on that front may be disappointed.

During the conference call, however, CEO Eric Schmidt assured investors that Google was in fact serious about holding down hiring costs.

“What we said last quarter, as you know, is that this is an area where we need to spend some more time and focus more on what is the appropriate rate. And the good news is we have done that. The numbers you are seeing are essentially an overhang, an overhang from hiring that had been agreed to many, many months earlier. June, of course, is a major college hiring, university hiring, professor hiring king of cycle. So I don’t know that that will be repeated. The important thing here is we did in fact correct, and I think going forward you’ll be comfortable that we’re paying a lot of attention to headcount.”

Other analysts hammered on the headcount question, including one who wondered why Google needed to hang onto the sales force of its recent acquisition, Postini. Google answered simply (if vaguely) that its sales representation will remain focused where it needs to be.

Schmidt’s comments seemed to placate early concerns that Google was entering a spendthrift era. The stock rebounded as the conference call wore on, and at this writing, is up slightly. Friday trading will show more
convincingly how investors will regard this earnings report.

When it filed to go public, Google said its operating costs might hurt margins so it could expand, and now we see that happening. Nothing indicates Google will back down from that vow. The question is how willing investors will be to withstand the pressure on margins if they continue to weigh down profit growth rates.