As earnings season kicks into high gear, all eyes will be on big tech. Alphabet (GOOG 0.66%) (GOOGL 0.49%) recently reported financial results for the quarter ended Sept. 30. Once again, the company showed noticeable progress in both its advertising unit and cloud segment as competition from TikTok, Meta Platforms, Microsoft, and Amazon lingers.
Over the last several months, Alphabet has invested significant capital in artificial intelligence (AI) applications and integrated the technology across all aspects of its business. Nonetheless, Alphabet stock appears to be taking a bit of a breather at the moment.
Let's dig into the Q3 report and take a look at how AI is fueling growth within Alphabet's ecosystem and assess if investors should scoop up some shares in the face of recent mundane pricing action.
Another solid quarter
The majority of Alphabet's revenue is captured in two categories: advertising and cloud. The table illustrates the revenue profile of each of these segments for the quarter ended Sept. 30.
| Item | Q3 2023 | Q3 2022 | % Change |
|---|---|---|---|
| Google Search and other | $44,026 | $39,539 | 11% |
| YouTube ads | $7,952 | $7,071 | 12% |
| Google Network | $7,669 | $7,872 | (3%) |
| Google advertising | $59,647 | $54,482 | 9% |
| Google other | $8,339 | $6,895 | 21% |
| Google Services total | $67,986 | $61,377 | 11% |
| Google Cloud | $8,411 | $6,868 | 22% |
Data source: Q3 earnings release. Dollar amounts in millions. Table by author.
On the advertising front, Alphabet increased revenue by 9%, which was primarily fueled by Google Search and YouTube. The company's Services business (which is mostly composed of advertising) grew 11%.
An important dynamic for investors to understand is that the majority of Alphabet's operating profits stem from Services. Per the earnings report, the company increased operating income for Services by 26% during the third quarter and boasted a 35% margin.
To put this into perspective, Alphabet's operating margin for Services in Q3 2022 was 31%. This is a massive expansion in margin, which flows straight to the bottom line.
For the quarter ended Sept. 30, Alphabet reported free cash flow of $22.6 billion, an increase of 40% year over year. By expanding margins and generating more excess cash, Alphabet has been able to invest in additional services and resources. Namely, the company's foray into generative AI is already yielding meaningful returns, underscored by a return to accelerating revenue in advertising, as well as consistently profitable cloud operations.
Let's dig into how Alphabet is integrating AI across the business and what management has to say about its future prospects.
Image source: Getty Images.
Building an artificial intelligence (AI) ecosystem
One of the more headline-grabbing topics last quarter was coverage of hedge fund manager Bill Ackman's position in Alphabet stock. During recent interviews, Ackman indicated that he is compelled by Alphabet because the company is in a unique position to leverage its vast data repository in such a way that can be stitched together across a wide array of products and services that benefit both consumers and enterprises.
Alphabet's management spent a good portion of the earnings call providing details around how AI is becoming more integrated into Search and Cloud. On the Search front, Alphabet rolled out a feature called Search Generative Experience (SGE). By layering generative AI into Search, Alphabet is effectively trying to increase its surface area on the Internet. Stated differently, SGE provides users with more links to choose from, thereby "creating new opportunities for content to be discovered."
While it is early innings for SGE, management appears optimistic about its potential to disrupt the existing advertising structure native to Search today.
Another promising opportunity rooted in AI is Alphabet's large language model. The model, dubbed Google Bard, was built to be "a complementary experience to Google Search." Since its commercial release earlier this year, Bard has made significant progress. The tool can now be used among many Google apps, including Workspace, YouTube, and Maps.
When it comes to the cloud, Alphabet's results are pretty impressive. The company shared that over half of start-ups focusing on generative AI and that have raised outside capital are customers of Google Cloud.
One of the core pillars of Google Cloud is a multifaceted product called Duet AI. Customers such as PayPal are using Duet AI to increase software development, while others are taking advantage of the tool's data analysis function within Google Workspace apps.
These dynamics underline precisely what Ackman was getting at. In a relatively short time frame, Alphabet has already integrated AI across several different aspects of its business. For this reason, investors could argue that the growth rates in the table have ample opportunity to eclipse their current profile.
Is Alphabet stock a buy?
GOOG PE Ratio data by YCharts
Alphabet stock is trading well below its prior highs on a price-to-earnings (P/E) and price-to-free cash flow basis. More specifically, the decline becomes more pronounced around the October window, shortly after the company released Q3 earnings.
There is no doubt that Alphabet faces stiff competition from Microsoft and Amazon when it comes to cloud computing and artificial intelligence (AI). But this financial review demonstrates how Alphabet is already benefiting from a suite of products and services connected by AI. Considering that the macroeconomy is still vulnerable to rising interest rates and inflation, I think it's appropriate to believe that Alphabet's advertising and cloud businesses are not even close to peak performance.
My fellow Fool Keith Speights recently referenced Alphabet stock as a "no-brainer buy." I wholeheartedly agree with that position and think now is an incredible opportunity to buy the dip in Alphabet stock and hold for the long term. Alphabet has made incredible progress on its artificial intelligence (AI) roadmap, and the company's strong liquidity profile suggests it has the financial horsepower to continue innovating and releasing additional resources at a fast pace.
As AI becomes more integrated across Alphabet's ecosystem, users should become more engaged and sticky, which will ultimately lead to further top-line growth and margin expansion. From my viewpoint, the current payoff from AI efforts is really encouraging, and the best is yet to come.
