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Google's Recipe for Profit

With its party line of "do no evil," Google calmed investors concerned that its altruism might get in the way of its business.

Financial analysts convened on Mountain View on Wednesday for the search giant's first Analysts' Day. A subtext of the day was reassurance that Google is not too untraditional to keep making money. Wall Street investors criticized the company for its initial public offering prospectus that proclaimed that it wouldn't explain itself to The Street.

"There's a big secret about Google," Schmidt told the analysts. "We're not quite as unconventional as we seem. In many cases, the things we do are unique, but the rest of the business is run in all the traditional ways. We have all the normal financial and IT systems and an independent board of directors."

While not an entirely false statement, Google's board is in fact packed with insiders.

Executives addressed concerns that it could do more to bring in revenue. The main search service will remain free, Schmidt said.

"We believe the simplest way to overcome a pricing issue with end users is to have the product be free and make money through other model like advertising," Schmidt said, noting this end-user focus creates more traffic that can then be monetized.

Neither does Google believe it should show ads whenever possible in an effort to maintain growth. Showing a chart linking quality of search results to revenue, Jonathan Rosenberg, vice president of product development, said, "We don't show ads when the query isn't commercial, so that we don't reinforce the behavior of ignoring ads." He admitted that Google could do more to raise the visibility of ads in some cases and pointed to partners as a good source of innovation.

For example, AOL, which uses Google AdSense to place contextual ads on content pages, recently added a link to lets users see more ads related to a query.

"A testament to the kind of advertising we're doing is that users actually click on it," Rosenberg said.

Schmidt explained that the company uses a 70-20-10 rule for allocating resources: 70 percent goes to the core search and advertising business; 20 percent go to related projects that extend the core search, such as Google News, the Froogle comparison shopping service, and the Gmail Web mail service; and 10 percent of work is exploratory, including the Orkut social network and the recently acquired Keyhole geospatial mapping technology.

Google employees are encouraged to devote 10 percent of their work hours to personal projects of interest, and many Google services began this way, co-founder Sergey Brin explained. To reward innovation -- and keep employees from leaving to found their own potential money machines -- the company instituted Founders' Awards in the form of restricted stock grants vested over four years. The two awarded to date have totaled around $12 million, Brin said.

"Even though a lot of Google's innovation comes from individuals in a bottom-up process," co-founder Larry Page told the analysts, "this doesn't mean we don't structure the company, have strategies, and decide what we're going to work on."

Page said the company is "pretty ruthless about prioritizing, so analysts shouldn't attach much importance to which products Google is now profiting from. Perpetually short-staffed, the company has to choose between improving existing services or monetizing new ones.

"We're not necessarily going to try to make money from all the things we do now," he said. "We know we'll eventually make money off [Google] News."

In response to complaints that Google services never get out of beta, Page said, "Part of our brand is that we under promise and over deliver. Being in beta is part of that." He explained that Google's engineers prefer to leave things in beta if they expect to make major changes. "We could take all our products off beta tomorrow," he said.

Schmidt said Google might instate registration for some services to increase the opportunity for personalization of results. "A Google that knows you and more about you," he said, could lead to "a much deeper advertising service."

In the final moments of the presentation, CFO George Reyes warned that Google won't be able to sustain its profit levels -- then backpedaled a bit.

"Very few businesses can maintain such large margins over time," he told the analysts.

Schmidt added that, while Google is committed to optimizing its capital expenditures, it will continue to invest heavily in engineering, which will drive down profit margins. "You shouldn't think about these things as happening tomorrow or next quarter," Schmidt said, "but they're trends that will happen over time."

Looking on the bright side again, Reyes added that growth in the advertising base might well mitigate that downward pressure.

Finally, Schmidt defended the unusual "triumvirate" management structure, where Schmidt, Page and Brin share typical CEO duties. Referencing the book The Wisdom of Crowds, Schmidt said having several people in the room to argue about decisions produced better results -- as long as there was a deadline. "Often," he said, " the outcome is not what we expect."