Economic downturns can be difficult for an advertising company like Alphabet (GOOG -1.22%) (GOOGL -0.95%). Many companies cut back on advertising spending during these times, as it is a manageable expense to control. Considering that 79% of Alphabet's revenue comes from advertising sources, these cuts create problems in Alphabet's financials.
However, Alphabet also has a bright spot: Google Cloud. In the third quarter, the segment proved businesses are still willing to build their cloud computing infrastructure, even if budgets tighten.
With Alphabet displaying both a red flag and a green one, which is more concerning to investors?
The red flag: Advertising growth is disappearing
As mentioned above, advertising spending is tightening up. In Alphabet's Q3, advertising sales only grew 2.5% year-over-year (YOY). This segment was a drag on the company overall, with revenue only rising 6% companywide in Q3. However, there were a few concerns within the advertising business segment itself.
|Google Search & other
While the primary advertising engine did fine, both YouTube and Google Network struggled. The primary concern here is YouTube, which was a significant part of Alphabet's growth story not long ago. However, YouTube will struggle as advertisers decrease their spending on social media platforms, but likely rebound when economic activity picks up.
Investors can nitpick the quarter all they want, but in the end, advertising sales still grew in an environment where many advertising companies (see Snap's quarter) failed.
Although this quarter may be difficult to be excited about, investors should relish it, as it's not far-fetched to imagine a quarter where Alphabet's revenue shrank. However, there's a green flag that investors should focus more of their attention on.
The green flag: Growth in cloud computing isn't slowing down
Although Alphabet's Google Cloud segment doesn't make up a considerable chunk of the company (Google Cloud's revenue was about 10% of Alphabet's total in Q3), it's a business that is shaping the next generation of computing and is a massive part of the Alphabet investment thesis. In Q3, Google Cloud's sales rose 37.6% YOY, accelerating from Q2's 35.6% growth.
While companies may be curtailing their advertisement spending, they are sparing no expense regarding cloud computing. That's because cloud computing and its benefits will shape business transformation over the next decade, which is part of why many investment research firms pinpoint the market opportunity at $1.6 trillion by 2030.
Google Cloud is nowhere near done growing, and this should excite investors. However, Google Cloud isn't profitable. In Q3, it posted an operating loss margin of 10.2%, which is an improvement from last year's 12.9% margin. Still, this weighed on Alphabet's net income, which fell $5 billion from last year to $13.9 billion.
Investors still have to decide if Alphabet's red flag is worse than its green flag is promising. To me, it's a no-brainer. Alphabet's red flag is only temporary. Once the economy emerges from the downturn, I expect YouTube to return to its prior growth narrative. This segment and the Google Search engine should ultimately drive a significant revenue and earnings increase, creating a massive catalyst for the stock.
Furthermore, Alphabet's green flag in cloud computing isn't slowing down anytime soon, and the segment should be a substantial growth driver over the next decade.
The stock remains a strong buy, with Alphabet's red flag only being temporary and its green flag being permanent.