The third-largest U.S. company by market cap, Alphabet (GOOG 9.43%) (GOOGL 9.54%) has been a disappointing investment recently. Since peaking in late 2021, the stock has marched straight down and is now nearly 40% off its all-time high.
While some investors may be worried about the current state of its business, I think three key facts must be considered to truly understand why Alphabet is still a fantastic investment moving forward.
1. Alphabet is addressing its operating expenses
One of the primary metrics that has investors concerned is Alphabet's falling operating margin. In the third quarter, it was 25% -- down from 32% last year. The primary culprit here was Alphabet's massive hiring spree. It brought on more than 35,000 workers in one year -- a 25% increase.
There are a couple of problems with this approach. First, it isn't easy to maintain company culture when so many new faces are brought on. Second, when you increase your headcount by 25% yet only grow revenue by 6%, it raises many questions about what good all these new hires are doing.
CEO Sundar Pichai addressed these concerns in the Q3 conference call by stating that the company is slowing its hiring pace in the fourth quarter and throughout 2023. However, he didn't commit to outright stopping this practice because "talent is the most precious resource." Still, he discussed moving around resources to focus on the most critical projects -- which is why a few Alphabet divisions have seen some relatively small layoffs.
Investors will learn more about how the company's expenses are trending in its Q4 earnings report on Feb. 2. Still, the biggest takeaway is that Alphabet's management sees multiple long-term opportunities and is willing to sacrifice short-term profits to capture the long-term market.
2. Google Cloud is a sleeping giant
Speaking of long-term markets, one of Alphabet's most exciting segments is its cloud computing division -- Google Cloud. While this division still loses money (it posted a 10% operating loss margin in Q3), multiple estimates put the global market opportunity at $1.6 trillion by 2030.
Considering Alphabet's market share is about 11% currently, that puts its revenue opportunity at around $176 billion by 2030 if it maintains its share. If you utilize the 26% operating margin of market leader Amazon Web Services (AWS) (the only profitable business in this space), then Google Cloud has the potential to produce $46.3 billion in operating profits by 2030. For comparison, Alphabet produced $78.3 billion in the previous 12 months.
Google Cloud has a ways to go with its operating profitability, as it has historically posted an operating loss margin of around 10% to 12% over the past year. However, its margins have trended in the positive direction, despite Alphabet heavily reinvesting in this space to capture a significant market opportunity. While it may be posting a loss now, this trend could flip if Alphabet reaches the same operating scale that AWS has.
Google Cloud also grew the fastest of the major cloud computing companies in Q3, indicating strong business momentum. The segment will likely be a business leader in 2023 and beyond and remains one of the top reasons to own the stock.
3. The advertising slowdown is temporary
Even though cloud computing is an exciting investment opportunity, advertising pays the bills at Alphabet. In Q3, advertising revenue made up nearly 80% of Alphabet's total, yet it only grew at a slow 2.6% pace in Q3. That slow growth can be blamed on the complex advertising environment caused by the economic slowdown.
This isn't the first time Alphabet has seen its advertisement revenue come under fire. The revenue shocks it experienced during 2008, 2013, and 2020, thanks to a slower economy, had a temporary effect, but Alphabet recovered quickly and set new revenue highs.
Anyone running for the hills due to a revenue growth slowdown is overreacting. However, it may take a couple of quarters for meaningful growth to return. Therefore, investors need to remain patient with the stock.
In the meantime, you can pick up Alphabet stock at essentially its lowest price-to-free cash flow valuation in the past decade.
GOOG Price to Free Cash Flow data by YCharts
With Alphabet, it all boils down to investors focusing on short-term headwinds instead of long-term trends. If you have the mindset to hold the stock for three to five years, then Alphabet looks like a screaming buy at its current price.
