Tech giant Alphabet (GOOGL 0.66%) (GOOG 0.56%) is commonly associated with Google's digital advertising business. After all, advertising income accounted for $54.5 billion of Alphabet's $69.1 billion in third-quarter revenue.
So on Oct. 25, when the company reported disappointing Q3 earnings in its ad business, the result propelled a stock price decline, reaching a 52-week low on Nov. 3.
The sell-off is an understandable reaction to Alphabet's modest 2.5% year-over-year Q3 ad revenue growth, combined with YouTube's first ever year-over-year ad sales decline since the division's revenue was broken out in 2019. Alphabet's weak ad revenue results were due to a slowdown in the advertising industry, sparked by this year's uncertain macroeconomic environment.
But the company possesses a potent business outside of advertising capable of reducing Alphabet's dependence on ad revenue. That business is Google Cloud, Alphabet's foray into the red-hot cloud computing market. Google Cloud alone makes Alphabet a compelling investment for investors with an eye on the long term.
Alphabet's cloud success
Alphabet's decision to participate in the cloud computing industry was a smart move. This industry is seeing strong growth, with a forecasted compound annual growth rate of nearly 20% over the next seven years. Alphabet's CFO Ruth Porat stated, "Enterprise customers are still early in their move to the cloud," signaling the potential for years of upside in Alphabet's cloud business.
Google Cloud is already successfully capturing its share of this growing market. The business currently ranks third among global cloud computing companies.
Google Cloud's year-over-year revenue has been rising by jaw-dropping double digits for several years. Last year's $19.2 billion in Google Cloud revenue was a 47% increase over 2020. This year, revenue has already hit $19 billion after three quarters, a 39% year-over-year growth rate. Google Cloud's revenue of $24.5 billion over the trailing 12 months now outstrips rival IBM's $22.2 billion over the same time period.
Google Cloud's ability to support massive scale has attracted many enterprise customers. Clients include Toyota, the Australia Securities Exchange, and Etsy. Companies such as Shopify and Paramount Global use Google Cloud as the backbone for key services, with the former employing Google Cloud to process millions of customer transactions, and the latter to deliver streaming services for its Paramount+ product.
Alphabet also launched the Google Public Sector program in June to capture customers in the government sector. The program counts the city of Los Angeles, New York state, and the U.S. Forest Service as clients.
Google Cloud's strengths
Google Cloud's success makes sense. It already delivers planetary-scale IT infrastructure to Alphabet's own businesses, such as YouTube and Gmail, which boast millions of global users. So enterprise clients see Google Cloud as a reliable alternative to competitors.
Also, Google Cloud's parent company serves as a potent funding source to fuel the division's growth. That's thanks to Alphabet's ability to generate strong free cash flow (FCF).
Alphabet produced $63 billion in free cash flow over the trailing 12 months. This is in spite of currency headwinds from a strong U.S. dollar, since more than half of Alphabet's 2022 revenue came from outside the U.S.
Porat stated Alphabet's intention to "continue to invest meaningfully" in Google Cloud and is focusing spending accordingly. To that end, in September, the company announced it was shutting down its Stadia video games division. That same month, Alphabet spent $5.4 billion to acquire cybersecurity firm Mandiant, marking the second-biggest acquisition in company history.
Mandiant will help Google Cloud proactively monitor computers, mobile devices, and other IT assets to quickly identify threats and vulnerabilities. The move strengthens Google Cloud's security at a time when protection from hackers is more challenging, given the rise in remote workers from just 23% of Americans before the coronavirus pandemic to nearly 60% today.
The Mandiant acquisition is only one example of how Google Cloud continues to evolve its offerings. It's also looking at ways to incorporate blockchain technology, the same tech used to power cryptocurrency, and is already leveraging artificial intelligence.
Google Cloud growth
Today, Google Cloud's business is overshadowed by Alphabet's much larger advertising income, but Google Cloud's revenue continues to rise vigorously despite deceleration in rivals. This bodes well for Google Cloud becoming the growth engine that helps Alphabet reduce its advertising dependence.
That growth potential can be seen in Alphabet's remaining performance obligations, which represents customer commitments for future services that have not been rendered yet, so isn't recognized as revenue. But it gives a sense for the revenue potential Google Cloud can unlock as these obligations are fulfilled in the coming months. At the end of Q3, Alphabet had $52.4 billion in remaining performance obligations, primarily related to Google Cloud.
Google Cloud also has the cloud computing industry's expansion as a tailwind. Industry forecasts predict the cloud computing market will grow from $405.7 billion in 2021 to $1.7 trillion by 2029.
Given the strength of its platform and how much it underpins Alphabet's own IT infrastructure, its history of success, and industry expansion in the years ahead, Google Cloud will continue to be a meaningful contributor to Alphabet's future growth, making Alphabet stock a worthwhile investment.
