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Google's Revenue and Profitability Is Getting Ready to Accelerate Again

By Nicholas Rossolillo - Feb 3, 2021 at 8:00AM

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Google Cloud has been a bigger drag on profitability than previously thought, but that's changing quickly.

Google parent Alphabet (GOOGL -0.21%) (GOOG -0.27%) just reported a knockout finish to 2020. Revenue and operating income increased a respective 23% and 69% year over year in the fourth quarter. So much for big tech losing steam.  

The biggest news, though, was Google revealing key details on its major reporting segments for the first time, most notably the operating margin for Google Cloud. The new insight provides a big clue that Google's growth -- and more importantly, its profit margins -- are gearing up for further rally in the year ahead.

Someone working on the equipment inside a data center.

Image source: Getty Images.

Google Cloud was crashing the party

For the last few years, Alphabet's operating profit margin (operating income as a percentage of total revenue) has been in steady decline. All sorts of ideas have been posited as to why, most notably that the core advertising business is getting less lucrative over time as it comes under regulatory pressure and new ad tech emerges.

GOOGL Operating Margin (TTM) Chart

Data by YCharts.

Don't get me wrong, operating margin over 20% is fantastic for a business the size of this one (full-year 2020 revenue was $182.5 billion). But the trend was nonetheless concerning. It turns out the advertising bread-and-butter is just fine, though. Google Cloud has been gobbling up a sizable chunk of cash as Alphabet fosters expansion at its nascent cloud computing business in a bid to play catch-up to cloud operations like Amazon's AWS and Microsoft's Azure.

Segment

2018

2019

2020

Google Services operating margin

31.5%

30.3%

30%

Google Cloud operating margin

(74.5%)

(52.1%)

(42.9%)

Total Alphabet (including Other Bets and unallocated corporate costs) operating margin

20.1%

21.1%

22.6%

Data source: Alphabet.  

Google Services is the new segment that encompasses Google Ads (the bulk of this segment at 87% of the segment total), YouTube and other subscription services, and the hardware business (like the Pixel lineup). While this area has indeed lost some steam in the last few years, it's Google Cloud that has secretly been the real culprit. However, the trend is reversing now, and total operating profit margin is picking up steam as the once tiny public cloud segment homes in on profitable scale. 

An incredible tech investment ecosystem

The implications here are intriguing. For now, Google is very much still a digital advertising business. Roughly 81% of total revenue in Q4 2020 was from ads. However, Google reinvests profits from its ad business by the billions into up-and-coming segments -- including Google Cloud -- at steep losses. But its heavy investment outlay is only just beginning to yield results. Google Cloud alone grew 47% year over year in Q4 and made up nearly 7% of total revenue. That's still a small slice of the pie to be sure, but paired with steep but fast-improving operating losses, this is a growing monster that will contribute to the bottom line in a big way in the next few years.  

Put another way, all indications point to an acceleration in Alphabet's total revenue growth and operating margin in the year ahead. Bear in mind that 2020 results include the worst of the economic lockdown at the beginning of the pandemic last spring -- when advertising activity slammed on the brakes and Google's financials took their first header since the financial crisis of 2008-09. As high of a note as 2020 ended on for the internet search leader, the table looks set for an even better 2021 as that most forgettable period of time is lapped. 

As of this writing, Alphabet stock trades for 32 times 2020 free cash flow. It isn't exactly cheap by traditional metrics, but it does look like a long-term value considering the direction this tech giant is headed. I remain a buyer.

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