Why Alphabet Is Much More Than an Advertising Company

Internet search giant Alphabet (GOOG 0.74%) (GOOGL 0.55%) has built one of the world's largest advertising businesses. If you type in a question to the company's search engine, Google, it is not surprising to see a handful of paid promotions sitting on top of actual search results. Similarly, Alphabet's video-sharing website, YouTube, often requires its users to preview ads before watching a video.

While advertising is still Alphabet's bread and butter, there is little denying that growth from ads is falling. One reason for this is a broader, macroeconomic effect of inflation. Due to higher costs of goods and services, advertisers are being more careful and more selective with budget allocations. Moreover, YouTube has been battling the widely popular short-form video app TikTok for quite some time. While YouTube still attracts billions of views, some advertisers may be questioning the direction the video website is going now that TikTok is gaining market share.   

Although these are valid concerns, there is one business underneath Alphabet's umbrella that seems to be overlooked and underappreciated. While overall growth at the company seems to be stalling, there is one shining gem: Google Cloud Platform. Let's dive into Alphabet's third-quarter earnings and the company's outlook, and hone in on Google Cloud and the various investments Alphabet has made to compete in this market.    

How important is the cloud?

Cloud computing is a generic term that encompasses many different concepts. For starters, the genesis of cloud computing spawned from the outdated way of storing data, namely on physical servers. As companies of all sizes collect, analyze, and synthesize more data, they rely more on storage. However, physical space is a finite resource and on-premise servers carry risks, such as overheating and lack of scalability. By contrast, storing data virtually (in the cloud) allows corporations to purchase more storage capacity as needed and scale more efficiently.

Another end market that cloud computing touches is cybersecurity. Since data has become more important for business leaders to make decisions, hackers view it as a desirable asset. Many large companies, including Wells Fargo, Equifax, and others, have all been the victims of noteworthy data breaches. Moreover, as more people work from home, the need to keep company-issued devices, such as phones and laptops, safe and secure is a high priority. For these reasons, the cybersecurity space has witnessed an influx of demand over the last several years.

Big tech has taken notice of these macro trends and have invested large sums into the cloud and cybersecurity specifically.  

Image Source: Getty Images.

It seems too good to be true

The tables below illustrate revenue, year-over-year growth, and gross profit from Google Cloud Platform and Amazon Web Services over the last five quarters.

Google Cloud Platform:

Data source: Investor Relations website, SEC Filings, figures in billions.

Amazon Web Services:

Data source: Investor Relations website, SEC Filings, figures in billions.

There is a lot to unpack from the data above. For starters, Amazon Web Services is nearly triple the size of Google Cloud Platform in terms of revenue. However, if we look underneath the hood, we can see that Google Cloud's quarterly revenue is growing at a much faster pace than Amazon Web Services. And although quarterly revenue-growth rates have been declining for both firms, Google Cloud is still generating nearly 40% annual growth compared to 30% for Amazon Web Services.

Another thing we should focus on here is operating income. Amazon Web Services is consistently generating a profit, whereas Google Cloud continues to lose money.

In a way, though, Google Cloud is almost operating like a start-up, and Amazon Web Services mimics more of a mature business. Part of the reason Google Cloud is losing money is because Alphabet has made some major acquisitions in the cloud space over the last year. As a result, Alphabet has ratcheted up hiring efforts for cloud developers and engineers, thereby incurring near-term costs.

On the surface, these investments appear to be paying off in the form of increased demand. While Alphabet has poured billions into augmenting its cloud platform, the company continues to generate consistent top-line growth and move toward operating efficiency.

A closer look at valuation

When it comes to valuing mature businesses such as Alphabet or Amazon, using multiples such as price to earnings or price to sales are typically reasonable methods. However, for these two companies, investors can almost think of the respective cloud segments as businesses within a business. Not too long ago, hedge fund manager Dan Loeb used this methodology to explain why he believes Amazon is undervalued. At a high level, his approach was to isolate Amazon Web Services as its own entity, analyze the growth prospects, and assign an appropriate market multiple to derive a fair value of just the cloud business relative to Amazon's entire company, inclusive of e-commerce.    

As of Q3 2022, Google Cloud is operating at an annual revenue run-rate of nearly $28 billion. Amazon Web Services is closing in on $100 billion of annualized revenue, yet Google Cloud is growing much more quickly. At the time of this writing, Alphabet has a market capitalization of roughly $1.1 trillion. If Google Cloud represents even just 10% of this value, that implies the cloud could become Alphabet's next $100 billion revenue stream. However, given the rate at which cloud is growing, especially compared to legacy businesses such as advertising, Google Cloud is likely worth much more than 10% of Alphabet.

For this reason, investors have an incredible opportunity right now to invest in a growing business inside of an already stable, blue-chip company. Now could be a terrific time to lower your cost-basis or initiate a position for long-term investors.