It cannot be denied Alphabet‘S (NASDAQ: GOOG)(NASDAQ: GOOGL) The third quarter results were great. Not only were the company’s revenue and earnings higher year-over-year, but both were also above analyst expectations.
However, the rise in Alphabet’s shares following the news added to the already large gains that first became visible a week earlier. Thanks to the post-earnings pop, Alphabet shares are now up an intimidating 12% in recent days. It’s the kind of move that many investors simply don’t want to pursue, for fear that a wave of profit-taking awaits them.
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If that’s you, you might want to hold your nose and dive in anyway. While there is certainly no guarantee that this rally will continue uninterrupted, this stock’s price still does not reflect Alphabet’s full potential. There is an underappreciated bullish force at work here.
For the three-month period ending in September, Google parent Alphabet turned revenue of $88.3 billion into earnings per share of $2.12. That’s significantly better than year-ago comparisons of $76.7 billion and $1.55, respectively. And perhaps even more bullish, these numbers exceeded analyst expectations for revenue of $86.3 billion and earnings of $1.85 per share. Most of this growth came from Google’s search advertising business.
However, there is a largely overlooked profit center that simply exploded last quarter. That’s Google’s cloud computing branch. Revenue improved 35% year over year to $11.6 billion, boosting operating income by a whopping 632% to $1.95 billion.
Data source: Alphabet Inc. Chart by author. Dollar figures are in billions.
It’s almost needless to say that the tech giant’s cloud business is (finally) reaching critical mass.
Don’t misunderstand. In the grand scheme of things, Google Cloud isn’t exactly a huge contributor to the bottom line. At least not yet. Cloud computing only accounts for about 13% of Alphabet’s third-quarter revenue, and just 7% of operating income. Every dollar helps, but it’s clearly not as important to the company as its search advertising business.
Data source: Alphabet Inc. Chart by author. Dollar figures are in billions.
However, take a close look at Google Cloud’s accelerating earnings trajectory and extend it for a few years (or more). Given the unit’s accelerating earnings growth, combined with Mordor Intelligence’s forecast for 16.4% annualized growth for the global cloud computing market through 2029, Google Cloud could certainly emerge as a serious profit center in the near future.
This idea underlines how modest Google Cloud’s operating profit margins still are compared to its competitors. Although 17% of turnover is again a new record for this Alphabet branch, it also pales in comparison Amazon Web Services’ current operating margin of 36% and MicrosoftThe operating profit margin of its cloud activities is around 45%.
What are these rivals doing that Alphabet isn’t? Nothing. They simply have more scale, which makes these larger margins possible.
Google Cloud is quickly reach that scale. It’s not inconceivable that Alphabet’s cloud computing business could generate annual operating income of around $30 billion per year, if not more, within the next five years.
Does any of this outright guarantee that Alphabet shares won’t fall below their current price at some point in the future? Certainly not. Technology stocks like these are inherently volatile. Furthermore, even though Google dominates the world’s search market, it faces respectable direct and indirect competition on multiple fronts. The price of an advertising click is also under constant pressure, because alternative advertising media such as streaming TV and in-app promotions are appealing to more and more advertisers. These are all factors that could weigh on Alphabet stock, if only because they weigh on investors’ perception of Alphabet itself.
On balance, though, Google’s search business is growing about as well as it’s ever been, while its cloud business is poised to become a major profit center. Even with the stock’s recent rally, this still doesn’t fully reflect the potential of this growth prospect.
What it comes down to? The bigger risk here remains the risk of missing out on more upside as more and more investors recognize the potential of Google Cloud.
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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, a director at Alphabet, is a member of The Motley Fool’s board of directors. James Brumley has positions at Alphabet. The Motley Fool holds positions in and recommends Alphabet, Amazon and Microsoft. The Motley Fool recommends the following options: long January 2026 $395 calls to Microsoft and short January 2026 $405 calls to Microsoft. The Motley Fool has a disclosure policy.
Yes, Alphabet Is Still a Buy After Earnings (But Not for the Reason You’d Think) was originally published by The Motley Fool
