Google parent Alphabet (GOOGL) sent shockwaves through the tech sector after releasing dismal Q3 2022 results that sent its stock price plunging to 52-week lows. As an internet analyst who has covered Google since its early days, I evaluate what‘s ailing this tech giant and whether investors overreacted.
Key reasons for the stock drop include a sharp slowdown in advertising revenue growth, Youtube monetization challenges, and margin compression from expenses rising faster than revenue. However, Alphabet retains dominant positions across digital ads and cloud computing with massive cash flows to cushion volatility.
While economic weakness weighs on performance over the near-term, compelling risk-reward upside exists for long-term investors.
Overview – From Dotcom Highflyer to Mature Tech Giant
Alphabet stock skyrocketed nearly 1,900% in the 16 years since its 2004 IPO to an October 2021 peak of $3,032 per share, returns outpacing the Nasdaq almost 2-to-1. However, its shares gave back over 30% year-to-date in 2022 as financial results hit speed bumps.
I‘ve extensively covered Google since the early 2000s as an internet business analyst, so understand well what drives its phenomenal cash generation capabilities when firing on all cylinders. Let‘s analyze key factors behind its stock drop this year.
Rapid Ascent Meets Economic Reality
During the pandemic, Google revenues surged as businesses flocked online and consumer internet usage exploded higher. Total sales shot up 41% in 2021 to nearly $258 billion as it dominated digital advertising and dented Amazon‘s cloud lead. Its stock price followed suit, more than doubling from pre-pandemic lows below $1,150 early in 2020 to ultimately eclipse the $3,000 milestone.
However, the inevitable comedown arrived in early 2022 as comparables got tougher and economic storm clouds gathered. Revenue grew just 23% year-over-year in Q1 and 13% in Q2 – huge numbers for most companies but considerable slowdowns compared to blowout 2021 gains.
Earnings took a bigger hit as heavy investments in talent, computing power, and real estate boosted expenses at nearly twice the pace of revenue growth. Operating margins compressed by around 800 basis points from Q1 2021 peaks as a result.
This margin pressure intensified after Q3 results disappointed investors across key financial metrics:
| Financial Metric | Q3 2021 | Q3 2022 | Y/Y Change |
|---|---|---|---|
| Total Revenue | $65.1 billion | $69.1 billion | +6% |
| Net Income | $18.9 billion | $13.9 billion | -26% |
| Operating Margin | 32% | 25% | -7 pts |
| EPS | $27.99 | $20.01 | -28% |
Data Source: Alphabet Quarterly Earnings Releases
The sharp deceleration in profit growth concerned the street and added to building fears of a looming recession. Businesses in industries like financial services, insurance, and crypto pull back even further on marketing expenditures while consumer spending slows.
Google stock plunged around 9% the day after reporting Q3 results, closing at a new 52-week low around $95. Roughly $600 billion in market cap went up in smoke since late 2021 peaks.
Let‘s analyze key factors driving this underperformance.
YouTube Headwinds Hit Core Ad Business
Google makes over 80% of revenue from advertising, so a pullback spells trouble, especially with macros worsening. But most concerning this quarter came from shrinking ad rates industry-wide and specific YouTube monetization struggles.
YouTube delivered mediocre user and viewing growth, but Ad revenue unexpectedly declined 2% year-over-year – the first drop since Google began breaking out the numbers. Short-form vertical video app TikTok captures more younger viewers’ eyes while audience metrics across Facebook, Snap, Twitter and others also declined in the quarter.
Rising competition vying for consumer attention plus recession fears lead brands to clamp down on marketing budgets. Google‘s core search business still grew steadily as commercial queries remained resilient. However, industry data indicates search ad pricing fell around 8% over last year, squeezing margins.
YouTube also shoots itself in the foot by aggressively pushing unmonetized Shorts content to viewers which may increase engagement but earns no ad revenue. Management highlighted plans to address this going forward.
Pandemic Hangover – Revaluing a Tech Giant
Zooming out, Google simply looked extraordinarily expensive during the pandemic‘s peak optimism. Its shares reached over 30X earnings and between 7-8X sales (see valuation history below) – pricing likely sustainable only if 2021‘s growth pace persisted for years.
| Year | P/E Ratio | P/S Ratio |
|---|---|---|
| 2019 | 27.2X | 6.1X |
| 2020 | 36.2X | 7.1X |
| 2021 | 28.3X | 8.8X |
| Current | 18.8X | 4.9X |
Data Source: Macrotrends
However, with revenue growth cut in half to just 6% last quarter, the market revalued shares closer to historical mid-20X earnings multiples. The selloff aligned with similar drops across big tech peers like Meta Platforms (META) and Netflix (NFLX) coming back to earth post-COVID.
Assuming growth reaccelerates as the economy rebounds and advertisers restore budgets, the ~30% drop this year arguably overshot and offers long-term upside from current levels.
Navigating Choppy Waters – Cost Resets and New Monetization
Alphabet announced plans during its earnings call to improve operating efficiency and direct resources towards the most promising growth drivers. Management set the bold aim is to operate more than 20% more efficiently which should alleviate margin pressure.
Initiatives include slowing headcount expansion dramatically after a 20,000 employee surge last year proved too much too fast. Additional cuts to discretionary spending like travel also free up cash flow for buybacks while continuing to invest selectively in AI computing power.
But smartly monetizing YouTube remains imperative to reviving growth. Shorts demands focus here after surging viewership but contributing little income due to skippable ads.
Management highlighted coming "great opportunity" bringing more marketers and creators onto Shorts plus testing other formats. They still characterize Shorts as early days like where core YouTube once was in moving through the funnel from engagement to monetization.
All About That Free Cash Flow
Stepping back from quarterly ups and downs, what attracted me to Google 20 years back remains the case today – its astronomy free cash generation enables tremendous flexibility. Despite compressing margins, Alphabet produced a staggering $23 billion in free cash flow last quarter alone and $30 billion through the first three quarters of 2022.
Alphabet funnels much of this cash towards aggressive share repurchases which both boost EPS and provide critical support for its stock price during selloffs like 2022‘s. Buyback expenditure accelerated to an unprecedented $15 billion last quarter alone, helping cushion downside.
Since 2018, Google shelled out over $90 billion recapturing shares outstanding to prop up equity value for remaining investors. Expanding cash flows should sustain heavy buybacks acting as a tailwind for long-term shareholder returns.
Data Source: Alphabet 10-Q Filings, Chart Created by Author
No End to The Google Money Machine
While economic weakness and competition weighed on growth this year, Alphabet exited Q3 in a dominant position across its markets. Google holds 29% share of the $178 billion US search advertising market which keeps expanding at a healthy clip.
YouTube now counts over 2 billion monthly active viewers – dwarfing competitors – and remains the de facto internet video platform. Management is keenly aware of the pressing need now to translate immense engagement into ad revenues as they fine-tune formats and offerings.
They also highlighted a massive emerging opportunity capturing budgets for YouTube video ads from linear TV markets. Americans alone watch over 4 hours of YouTube content daily as audiences shift online.
Closing the gap with cloud leaders AWS and Microsoft Azure also progresses steadily, expanding Google Cloud‘s share to around 10% now of the cloud infrastructure market. Cloud revenue grew almost 40% last quarter to $6.9 billion. There exists enormous potential still to come as more enterprise workloads move to the cloud.
While economic volatility impacts performance right now, Google‘s dominant positioning across these key digital spheres ensures its cash generation engine keeps humming over the long run.
Bottom Line for Investors
In summary, fears over a dangerous macro slowdown crushing digital advertising demand hammered shares down to attractive levels for long-term investors. Businesses slash marketing budgets in a downturn but eventually restore spending as conditions improve in the cycle.
Meanwhile, Alphabet distinctly navigates the storm better than most with fortress-like balance sheet with $125 billion in cash to shield volatility and keep rewarding shareholders. Consider that free cash flows last quarter alone covered almost 20% of its entire market cap.
For those with tolerances to withstand near-term bumpiness, the risk-reward looks compelling at under 20X earnings for a world-class franchise. My projections based on expected trends in digital marketing and cloud computing point to low double-digit revenue expansion resuming as headwinds abate by late 2023 or early 2024.
Wall Street analysts also forecast resilient earnings power through temporary weakness with EPS recovering back above $5 by 2024, implying 45%+ upside from current levels. An excellent entry point exists here for investors riding tremendous innovation waves for years to come.
