Is Google Actually Winning the Cloud Wars?

The cloud infrastructure trio all saw their stocks sell off this earnings season, as cloud spending decelerated across all vendors.

That is, except one.

Investors don't seem to pay much attention to Alphabet's (GOOG 9.96%) (GOOGL 10.22%) Google Cloud Platform. For short-term investors, that may make sense, as Alphabet's digital-ads empire provides virtually all of Alphabet's profits, while the Google Cloud Platform makes an operating loss.

Yet even though Alphabet's stock fell on disappointing digital-ads revenues, its cloud unit offered lots of reasons for optimism -- and investors are basically getting it for free.

Google Cloud is gaining on rivals

Cloud leaders Amazon (AMZN 3.43%) Web Services and Microsoft (MSFT 1.82%) Azure have long been the de facto number one and two in the cloud infrastructure market, with Google a distant third. Amazon Web Services (AWS) is the outright leader, and its economies of scale have allowed it to garner high operating margins in the 25% to 35% range. While Microsoft doesn't break out margins specifically, the company's overall margins are high and have been widening over the past few years as Azure has become a larger part of the business.

However, the recent quarter may indicate a shift in the narrative. While both AWS and Azure decelerated, Google's cloud division accelerated growth. Moreover, Google Cloud platform grew at a higher rate than Azure and nearly 10 points more than AWS, which is a rare occurrence.

Data source: Amazon, Microsoft, Alphabet Q3 earnings reports. YOY=year-over-year. 

Under Google Cloud CEO Thomas Kurian, it appears as though the heavy investments in technical and sales roles are paying off. Through improved and open relationships with channel partners, while opening up Google's in-house cybersecurity capabilities to its cloud customers, it appears as though Google Cloud is gaining share. And with the $5.4 billion acquisition of leading cybersecurity firm Mandiant just closing in mid-September, Google is looking to differentiate its cloud offerings on the basis of in-demand data analytics and cybersecurity even further.

In a recent interview, Kurian said investors shouldn't be worried about Google Cloud's profitability, as the company has a "clear line of sight" to becoming quite profitable. At Alphabet's recent Cloud Next conference, Kurian elaborated the very simple thesis:

If you look at the cloud business, it's a relatively high fixed-cost business: You need to build a global network of data centers, a broad set of solutions, and you need significant numbers of salespeople -- and those are all fixed costs... So, with those high fixed costs in place, how do you make the business profitable? You scale it. And that's what we're doing... It's just a matter of time.

On that note, while Google Cloud's operating losses expanded slightly in dollar terms over the prior-year quarter, from a $644 million loss to a $699 million loss, operating margins as a percentage of revenue actually improved from (12.9%) in the year-ago period to (10.2%).

What kind of value is assigned to Google Cloud?

Google Cloud hasn't gotten much credit from investors. After all, Alphabet trades at just 18.8 times generally accepted accounting principles (GAAP) earnings -- and those earnings include the effect of significant operating losses under Alphabet's "other bets" segment, declines in Alphabet's equity investees, $700 million of operating losses at Google Cloud Platform last quarter, and nearly 10% of its market cap in net cash.

Stripping out those factors, and the core business is probably trading at a low-to-mid-teens multiple, which seems way too cheap for the world's go-to Search engine, YouTube, and Google Play app store, among other profitable divisions. 

At nearly a $28 billion run rate, growing in the high 30% range, with narrowing operating losses and increasing market share, one has to think Google Cloud has significant value. However, at Alphabet's current overall valuation, investors may be getting this growing asset thrown in with very little value ascribed to it.

While the upcoming year will be challenging as the economy slows and companies pull back on advertising, Alphabet sure looks like a bargain when taking a long-term view.