When digging into Alphabet's (GOOG -1.96%) (GOOGL -1.97%) latest business results, it's easy to focus on slowing advertising demand or its rising headcount. While these are understandable considerations, they shouldn't outweigh what I think is the most critical part of Alphabet's third quarter.
The star of the show should be Google Cloud and how well this segment has been performing for Alphabet. I believe it represents the strongest case for the stock. Let's find out why.
Google Cloud has immense potential
In Q3, Google Cloud's revenue rose 38% year over year to $6.9 billion. Its two largest competitors, Amazon's Amazon Web Services (AWS) and Microsft's Azure, saw revenue growth of 27% and 35%, respectively. So from a sales growth standpoint, Google Cloud had the best quarter of the three.
However, Google Cloud isn't as big as AWS or Azure; it's about a third of the size of AWS. When you're smaller, it's easier to grow faster, which is why I am bullish on Alphabet's stock. Management is also excited about the momentum Google Cloud experienced in Q3 and expects to continue its success moving forward.
One caveat with Google Cloud is its unprofitability. In Q3, its operating expenses outweighed its revenue, and it lost $699 million. Compared to AWS' 26% operating margin, it has some distance to catch up.
Management has been up front with investors about heavily investing in Google Cloud because it believes it is a significant market opportunity. Third-party research firms agree, too; Precedence Research projects the market opportunity to swell to $1.6 billion by 2030 with a compound annual growth rate of 17.4%
Over the past 12 months, Google Cloud has generated $24.5 billion in revenue. If the segment can grow at a 30% compound annual growth rate (ambitious, but AWS and Azure have accomplished the same feat), then Google Cloud will be producing $70 billion annually in four years.
Now, if Google Cloud achieves a 25% operating margin during that time (slightly less than AWS' historical margin), it would generate an additional $17.5 billion in operating income. For reference, Alphabet's total operating income in Q3 was $17.1 billion.
That's how big of an opportunity the cloud is today. And a $70 billion run rate isn't far-fetched either -- it's about AWS' current annual run rate. While four years may seem like a ways off, other catalysts should help propel Alphabet's stock in the meantime.
Advertising revenue isn't gone forever
As businesses begin to control their costs in preparation for an economic downturn, advertising budgets are reduced, which affects Alphabet's primary revenue stream. With Alphabet's advertising sales rising only 2.5% in Q3, investors could be worried as advertising sources make up nearly 80% of Alphabet's current revenue.
However, this is a regular occurrence, and advertising revenue has always returned in force after the economy tanks and recovers.
GOOG Revenue (Quarterly YoY Growth) data by YCharts
While I'm not sure how much revenue growth Alphabet will deliver during this recovery, history shows it's been about 20% growth, at least during the past decade.
Combined with the booming cloud business, Alphabet's recovery could be extraordinary, and so investors should use the short-term weakness as their chance to get in on what will likely be a market outperformer over the next five years.
In the meantime, investors may have to deal with a stagnant or falling stock price as the market corrects in the short term to adjust to the company's current weaker state. I'm confident in Alphabet's long-term status, even if the short term is uncertain.
