After seemingly being beaten to the punch by other companies launching artificial intelligence (AI) chatbots, Alphabet's (GOOG 1.25%) (GOOGL 1.27%) patience may have paid off. Microsoft's Bing chatbot has been criticized for giving answers to questions that are quite disturbing, including reportedly telling one user he should leave his wife.
Still, the damage was done to Alphabet's stock, with it only up 6% year to date, which lags the Nasdaq Composite's 10% return. However, this is a short-sighted argument, and individual investors should be focused on the long term. So let's look at where Alphabet might be in three years -- the conclusion may surprise you.
Alphabet's advertising revenue streams have caused a growth slowdown
While Alphabet has multiple revenue streams, its primary business boils down to three segments: advertising, "Google Other," and cloud computing. Advertising makes up most of the business, generating 78% of the revenue during Alphabet's fourth quarter. Thanks to the challenging economic environment, this segment fell 3.6% year over year as advertisers are tightening their budgets. This correlates strongly with a historical trend that as recessions approach, Alphabet's revenue growth grinds to a halt.
GOOG Revenue (Quarterly YoY Growth) data by YCharts
But another key takeaway from this chart is that shortly after the recession probability spikes, Alphabet's revenue growth spikes. This is due to a wave of advertising spending that occurs as the U.S. emerges from a recession. So in three years, don't be surprised to see Alphabet return to its mid- to high-teens revenue growth. Wall Street analysts project 11.6% revenue growth on average for 2024. However, this year's revenue is only expected to grow by 4.7%, so 2023 will continue to be a tough year.
The "Google Other" segment hides some pretty valuable properties, including its Google Play app store, YouTube and YouTube TV subscriptions, as well as hardware. This segment rose 8% in Q4.
In the conference call, management mentioned that Google Play revenue declined. However, Chief Business Officer Philipp Schindler mentioned strength in a couple of areas: YouTube subscription growth and hardware. CFO Ruth Porat noted that the Pixel family drove most of the hardware growth, so Alphabet's longtime smartphone investment may finally pay off. Additionally, YouTube Music Premium and YouTube TV saw significant subscriber growth.
That's a big deal for Alphabet, as YouTube TV opens the door for personalized TV ads, a vast and lucrative market. This has the potential to boost ad revenue growth when ad revenue returns after the economic slowdown concludes.
However, the cloud computing segment should excite investors the most.
Google Cloud is a sleeping giant
In Q4, Google Cloud rose 32%, the fastest among major cloud computing competitors. Granted, Google Cloud is in third place, behind Microsoft Azure and Amazon Web Services (AWS). Still, outpacing their growth is impressive and shows Alphabet is gaining ground.
While unprofitable, Google Cloud is rapidly heading toward profitability.
| Quarter | Google Cloud Operating Margin |
|---|---|
| Q1 2022 | (16%) |
| Q2 2022 | (13.7%) |
| Q3 2022 | (10.2%) |
| Q4 2022 | (6.3%) |
Data source: Alphabet.
For reference, AWS posted an operating margin of 24% in Q4, which shows Google Cloud has a ways to go.
Should Google Cloud reach that level of profitability within three years, it will greatly affect Alphabet's earnings. Take Q4's numbers for example: Alphabet posted an operating profit of $18.2 billion. If Google Cloud attained that 24% operating margin, this number would rise to $20.4 billion, a 12% increase.
This segment holds the keys to Alphabet's future and will be an important factor if it achieves profitability in three years.
Alphabet's future is bright; however, the stock trades at a historically cheap 20.7 times earnings.
GOOG PE Ratio data by YCharts
Right now looks like an excellent time to capitalize on the short-term pessimism behind Alphabet's stock. The economy should be rolling again in three years, bringing increased advertising revenue to Alphabet. Additionally, the effect of a profitable Google Cloud will be noticeable and add to an already great company's investment thesis.
I'm a buyer of Alphabet's stock here because I think it has strong potential to beat the market over the next three to five years.
