Alphabet (GOOG 0.74%) (GOOGL 0.55%) is one of the biggest companies in the world, but even it is not immune to challenges. The company offers most of its services to customers for free, so it relies on advertising to generate revenue.
That puts Alphabet at risk of the same forces the industry faces. Two red flags for Alphabet in 2022 are the increasing ad supply entering the market and macroeconomic forces lowering marketers' spending appetite.
1. Increasing advertising inventory
Interestingly, the advertising industry is no different than others regarding the laws of supply and demand. If you recall from introductory economics, when supply increases, prices decrease. Unfortunately for Alphabet, a mass of new advertising inventory is coming online at the end of this year. Netflix, one of the world's biggest streaming services in terms of subscribers and viewership, is launching an ad-supported tier of its service. That will bring new advertising inventory marketers will undoubtedly be interested in buying.
To make matters worse, Disney is launching an ad-supported version of its most popular streaming service later this year. Chances are, marketers are not going to increase their ad budgets to include purchases of the new ads. Instead, they will likely reduce their allocation among existing investments to spread across Netflix and Disney+. Alphabet is the biggest advertising company in the world, generating $258 billion in ad revenue last year; it is poised to experience financial pain from these shifts in the advertising market.
2. Macroeconomic headwinds
The coronavirus pandemic has cascading consequences worldwide. Many of those factors are causing marketers to reduce budgets. In Alphabet's most- recent quarter, which ended on June 30, overall revenue increased by just 13%. That comes after revenue increased by 62% in the same quarter of the year before. Supply chain shortages are common now. An outbreak at a manufacturing facility can send workers home for a week or more, significantly reducing output. Customers are getting familiar with the sold-out sign. If businesses don't have products to sell, there is little need to advertise.
U.S. Consumer Price Index YoY data by YCharts.
Despite supply shortages, customer demand has remained resilient. I will put on my professor's cap again: If you have strong or increasing demand and decreasing supply, prices increase. The consumer price index, which measures the price of a typical consumer's basket of goods, increased by 8.5% in the U.S. in August. With folks paying more for necessities like gas, rent, and food, it leaves less discretionary spending. Businesses in those industries have noticed and have begun reducing their advertising budgets.
No reason to sell Alphabet stock
GOOG Price to Free Cash Flow data by YCharts.
Admittedly, these red flags will make a meaningfully negative impact on Alphabet in 2022. However, that is no reason to sell the stock. Alphabet's shares are trading at a relatively reasonable valuation when measured by the price-to-free-cash flow of 23, which is near the lowest in recent years. That leaves room for the company to experience lower cash flows yet remain an attractive investment.
