Alphabet Stock Is a Buy and It’s All Thanks to Google Cloud

tech giant alphabet (GOOGL 2.21%) (WELL 2.25%) is commonly associated with Google’s digital advertising business. After all, advertising revenue accounted for $54.5 billion of Alphabet’s $69.1 billion in third-quarter revenue.

When the company reported disappointing Q3 results from its advertising business on Oct. 25, the result caused its share price to fall, hitting a 52-week low on Nov. 3.

The selloff is an understandable reaction to Alphabet’s modest 2.5% year-over-year ad revenue growth in the third quarter, combined with YouTube’s first year-over-year decline in ad revenue since the division’s earnings were announced in 2019. Alphabet’s weak ad revenue results were due to a slowdown in the advertising industry, sparked by this year’s uncertain macroeconomic environment.

But the company has a strong non-advertising business that may reduce Alphabet’s reliance on advertising revenue. That business is Google Cloud, Alphabet’s foray into the red-hot cloud computing market. Google Cloud alone makes Alphabet a compelling investment for long-term investors.

Alphabet’s cloud success

Alphabet’s decision to get involved in the cloud computing industry was a smart move. This industry is experiencing strong growth with a projected compound annual growth rate of nearly 20% over the next seven years. Ruth Porat, Alphabet’s CFO, stated, “Enterprise customers are still in the early stages of their move to the cloud,” signaling the potential for years of upside in Alphabet’s cloud business.

Google Cloud is already successfully capturing its share of this growing market. The company is currently ranked third among global cloud computing companies.

Google Cloud’s annual revenue has been growing by a staggering double digits for several years. Last year’s Google Cloud revenue of $19.2 billion was a 47% increase from 2020. This year, revenue after three quarters has already reached $19 billion, a year-over-year growth rate of 39% . Google Cloud’s $24.5 billion trailing-12-month revenue now surpasses the competitor IBM$22.2 billion in the same period.

Google Cloud’s ability to support massive scale has attracted many enterprise customers. Belong to the customers Toyotathe Australian Stock Exchange and Etsy. companies such as Shopify and Paramount Global uses Google Cloud as the backbone for key services, with the former using Google Cloud to process millions of customer transactions and the latter to provide streaming services for its Paramount+ product.

Alphabet also launched the Google Public Sector program in June to attract customers in the government sector. The program’s clients include the City of Los Angeles, New York State, and the US Forest Service.

The strengths of Google Cloud

Google Cloud’s success makes sense. It already provides IT infrastructure on a global scale to Alphabet’s own companies, such as YouTube and Gmail, which boast millions of users worldwide. As a result, enterprise customers see Google Cloud as a reliable alternative to competitors.

Additionally, Google Cloud’s parent company serves as a strong source of funding to fuel the division’s growth. That’s thanks to Alphabet’s ability to generate strong free cash flow (FCF).

Alphabet generated $63 billion in free cash flow over the trailing 12 months. This is despite currency woes from a strong U.S. dollar, as more than half of Alphabet’s 2022 revenue will come from outside the U.S

Porat stated Alphabet’s intention to “continue to make meaningful investments in Google Cloud” and is concentrating spending accordingly. To that end, the company announced in September that it was closing its video game division, Stadia. In the same month, Alphabet spent $5.4 billion to acquire cybersecurity company Mandiant, making it the second-biggest acquisition in the company’s history.

Mandiant will help Google Cloud proactively monitor computers, mobile devices and other IT assets to quickly identify threats and vulnerabilities. The move strengthens Google Cloud’s security at a time when protecting against hackers is more of a challenge, given the rise in teleworking from just 23% of Americans before the coronavirus pandemic to nearly 60% today.

The acquisition of Mandiant is just one example of how Google Cloud is evolving its offerings. It’s also looking at ways to integrate blockchain technology, the same technology used to power cryptocurrencies, and already uses artificial intelligence.

Google cloud growth

Today, Google Cloud’s business is overshadowed by Alphabet’s much larger ad revenue, but Google Cloud’s revenue continues to grow strongly despite the slowdown of its peers. This bodes well for Google Cloud becoming the growth engine that will help Alphabet reduce its reliance on advertising.

This growth potential is reflected in Alphabet’s remaining performance obligations, which represent customer obligations for future services that have not yet been performed and are therefore not recognized as revenue. But it does give a glimpse of the revenue potential Google Cloud can unleash if those commitments are met in the coming months. At the end of the third quarter, Alphabet had $52.4 billion of outstanding performance obligations, primarily related to Google Cloud.

Google Cloud also has the expansion of the cloud computing industry as a tailwind. Industry forecasts predict that the cloud computing market will grow from $405.7 billion in 2021 to $1.7 trillion in 2029.

Given the strength of its platform and how much it underpins Alphabet’s proprietary IT infrastructure, track record of success, and industry expansion in the years to come, Google Cloud will continue to be a significant contributor to Alphabet’s future growth, which will drive Alphabet stock makes it a worthwhile investment.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Robert Izquierdo has positions in Alphabet (A shares), Etsy, IBM, Paramount Global and Shopify. The Motley Fool has positions in and recommends Alphabet (A shares), Alphabet (C shares), Etsy, and Shopify. The Motley Fool recommends the following options: long January 2023 $1,140 calls on Shopify and short January 2023 $1,160 calls on Shopify. The Motley Fool has a disclosure policy.