America's largest technology companies -- specifically, those in the "Magnificent Seven" -- make up almost 30% of the total value of the S&P 500, so changes in their stock prices can have a major impact on the broad market index.
All eyes are on those giants right now because they are reporting their financial results for the quarter that ended Sept. 30. Google parent Alphabet (GOOGL -0.93%) (GOOG -0.91%) is one of the standouts so far, but not in a good way.
Since Alphabet released its results on Oct. 24, its stock price has fallen by 12% as investors digested a slowdown in growth in the company's cloud computing segment, which is home to many of its artificial intelligence (AI) initiatives. But I think that decline creates a spectacular long-term opportunity for investors.
What investors didn't like about Alphabet's Q3 results
The cloud has become the center of the universe for the technology sector. Companies like Alphabet manage enormous data centers and rent capacity from them to millions of businesses around the world, which use them to store their valuable digital assets.
Alphabet's Google Cloud division has some of the most popular infrastructure for training artificial intelligence applications -- infrastructure that was built using its own tensor core processor (TPU) chips, and Nvidia's graphics processor (GPU) chips. The platform also offers developers a selection of over 100 ready-made AI models they can build upon, and Google said the number of customers accessing them surged sevenfold in the space of one quarter.
While all of that sounds fantastic (and it is), Google Cloud's revenue grew by just 22% year over year in Q3 to $8.4 billion, which was far slower than Wall Street analysts expected. To make matters worse, one of its main competitors, Microsoft Azure, delivered growth of 29% in the same period. Since Google Cloud is only the third-largest cloud provider behind Azure and Amazon Web Services, it can't afford to cede market share.
Nevertheless, Google Cloud only accounts for 10.9% of Alphabet's total revenue, so it isn't the chief driver of the company's financials. But investors do perceive it as critical to Alphabet's future, especially as AI adoption grows, and that's why its stock was hit so hard last week. On the flip side, there are two big reasons to buy the dip.
1. The advertising market is bouncing back, and Google Search revenue accelerated
Google Search is the world's most-used internet search engine, with a market share of 91%. It also provides 57% of Alphabet's overall revenue. Google Search generates income through advertising, and the segment has slumped over the last 18 months as businesses cut their marketing budgets amid a tough economic climate driven by elevated inflation and rising interest rates.
But there are clear signs those headwinds are easing, and search revenue has accelerated for three consecutive quarters. After it shrank by 1.6% on a year-over-year basis in Q4 2022:
- It grew by 1.9% year over year in Q1 2023;
- It grew by 4.8% in Q2, and;
- It grew by 11.3% in Q3 to $44 billion.
But an improvement in the broader economic environment isn't the only thing driving that recovery. Microsoft brought substantial changes to the search industry earlier this year when it integrated OpenAI's ChatGPT technology into its Bing search engine. Now, users can prompt Bing to get direct answers to their queries, which is a far more convenient experience than traditional search engines offer.
Alphabet has invested heavily in generative AI tools for Google Search to fend off the threat from Microsoft. Now, when a user runs a search on Google, it offers an AI-generated text-based answer at the top of the page, which can save them from having to sift through web pages for the information they're looking for. Plus, Google continues to develop its Bard chatbot, which is a direct competitor to ChatGPT, so the platform will be prepared if a more pronounced shift away from traditional search does occur.
In another sign the broader advertising market is bouncing back, Alphabet's YouTube video streaming platform also saw a 12.4% year-over-year increase in revenue during Q3, which was its fastest growth rate in 2023 so far. Investors should expect further momentum from YouTube for the rest of this year because it has the rights to the NFL's Sunday Ticket, which will drive subscription revenue. Plus, engagement with its Shorts feature -- which competes with ByteDance's TikTok -- is near record highs, with 70 billion daily views and 2 billion monthly active users.
Image source: Google.
2. Alphabet's profit soared in Q3
Like most tech giants this year, Alphabet has focused on managing costs in light of the challenging economic climate. It ended Q3 with 182,381 employees, which was a 2.3% reduction from the same time last year, and it also spent a little less money on expense categories like sales and marketing during the quarter.
Combine that with the acceleration in Google Search and YouTube revenue, and the result was more profit on the bottom line. Alphabet's Q3 earnings per share came in at $1.55, which was an impressive 46% increase year over year.
That took the company's trailing 12-month earnings to $5.21. At the current share price, that gives Alphabet stock a price-to-earnings (P/E) ratio of 23.4. It makes the stock about 26% cheaper than Microsoft, which trades at a P/E of 31.8. It's also about 21% cheaper than the technology sector more broadly, represented by the Nasdaq-100 index, which trades at a P/E of 29.9.
In fact, Alphabet stock is trading at the cheapest P/E ratio of any of its peers with valuations of greater than $1 trillion. Considering its core business appears to be firmly on the upswing, that suggests an opportunity for investors.
