Google Cloud Hit a Snag, but Here's Why Alphabet Stock Is a Buy Anyway

Shares of Alphabet (GOOG 1.75%) (GOOGL 1.68%) were down some 10% after its third-quarter earnings update. The blame is falling on slowing growth in Google Cloud, a key driver now that Google Search and other various advertising businesses have matured.

Google Cloud now makes up 11% of total Alphabet revenue after growing 22% year over year, slower than the high-20s percentages that have been reported in past quarters.

Nevertheless, Alphabet stock has still had a sizable rebound this year, and it looks like a reasonable value again after this update in spite of a brief snag for Google Cloud.

What happened at Google Cloud anyway?

Last quarter, Google Cloud had reported year-over-year growth of 28% to $8 billion in revenue. Alphabet CEO Sundar Pichai commented on how the majority of artificial intelligence (AI) "unicorns" (private start-ups with a valuation of at least $1 billion) were using Google Cloud. 

With growth this quarter at just 22%, to $8.4 billion, it seems the AI hype is losing some steam for Alphabet's cloud infrastructure service. But is it really? Consider two points:

• Pichai said that over 60% of the world's thousand-largest companies are Google Cloud customers. With cash conservation a top priority for big business in 2023, right-sizing cloud spending has been called an ongoing drag on growth for Google Cloud as well as its peers like Microsoft Azure and Amazon Web Services (AWS).
• Google Cloud was also lapping particularly strong growth in the 2022 third quarter. Though it looks like the business is cooling off, year-over-year growth for the cloud segment was still coming off peaks last summer, which is having an effect on the reported growth rates now.

Data source: Alphabet. YoY = year over year. 

Besides, all-out revenue growth isn't the real reason to bet on Google Cloud anymore. As I've written over the last three years, the real big mover for Alphabet stock in terms of its cloud business is the flip from operating losses to operating income.

In the third quarter of 2023, more progress was reported, as Google Cloud went from an operating loss of $440 million a year ago to operating income of $266 million this year.

Though Google Cloud is still a small piece of the Alphabet pie, it's having a big impact on operating profit margins overall. The total operating margin improved dramatically to 28% this last quarter, compared to 25% a year ago, and helped lead to a big 46% year-over-year gain in earnings per share (EPS).

Alphabet faces risks but is still a top long-term play

The company is also getting a great lift from a more gradual rebound in its big advertising business and faster-rising profitability as the company looks to things like AI to become more efficient. But there are risks to the internet empire.

Chief among them could be an antitrust lawsuit, with the Department of Justice and others claiming that Google has wielded unfair market power in squashing digital ad competitors. This trial could have a range of outcomes -- like Alphabet needing to split into two businesses, sell off assets, or being forced to stop paying peers like Apple to make Google the default web browser on its devices.

Or nothing might happen. In the late 1990s, Microsoft was sued as well for trying to monopolize the PC market and lost. It later appealed and won, settling with the Justice Department instead. Microsoft's undoing in PC monopolization ultimately was the rise of mobile computing, which got a big boost just a few years later from Apple's iPods and later the iPhone. 

The Google antitrust case could unfold similarly, with a wave of competition in digital ads (led by the likes of The Trade Desk) already unfolding for the internet search stalwart. A big difference between Google now and Microsoft of the 1990s, though, is valuation.

Back then, Microsoft was sometimes valued at 70 times trailing-12-month EPS (or even upward of 80) and had no clear path to reinvigorating its business after the dot-com bubble burst. Today, Alphabet stock trades for 27 times trailing-12-month EPS, and Google Cloud has become an obvious pillar that its parent can rely on for strong future earnings growth.

Thus, even when considering the risks, I think Alphabet is still a buy right now. Google Cloud remains in strong growth mode, and operating income is only just beginning to get rolling.