Alphabet's ad business slows to a trickle. Time to sell?

The recession is coming for the search giant.

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This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Coming into Alphabet Inc's (NASDAQ: GOOG) (NASDAQ: GOOGL) third-quarter earnings report on Tuesday night, there were already signs that growth would be sluggish.

Fellow digital advertising stock Snap Inc said revenue growth slowed to just 6% in its third quarter, and Alphabet management had already warned about macroeconomic uncertainty in its second-quarter earnings report.

Those fears were validated when the Google parent posted third-quarter results that were even worse than expected.  

Revenue increased just 6%, or 11% in constant currency, to $69.1 billion and ultimately missed estimates at $70.6 billion. On the bottom line, operating income fell 19% to $17.1 billion, and earnings per share shrank from $1.40 in the quarter a year ago to $1.06 (below the analyst consensus of $1.25). The stock fell 6.6% in the after-hours session on Tuesday night. 

Advertising screeches to a halt

While Google Cloud and the projects in the "other bets" segment, like the autonomous driving service Waymo, get some attention from investors, Alphabet is fundamentally an advertising business, and advertising makes up essentially all of its profits, as Google Cloud and other bets lose billions of dollars each year.

Google Search still drives a majority of the company's revenue and profits, making it the biggest determinant of the company's success.

In the third quarter, revenue from the search segment increased just 4.3% to $39.5 billion, while YouTube's top line fell for the first time since the company broke out its results, declining 2% to just over $7 billion. Revenue at Google Network, which is made up of Google ads on non-Google properties, also fell 1.6% to $7.9 billion.

Management noted that the stronger dollar was partly responsible for the weak growth and said that lapping rapid growth in the quarter a year ago when overall revenue jumped 41% was the main reason for the underwhelming performance.

However, Alphabet's overall revenue also declined sequentially, and advertising revenue slipped 3.2% from Q2 to $54.5 billion, a clearer sign that macroeconomic headwinds are weighing on the business.

On the earnings call, the company said it saw a pullback in verticals, including financial services like insurance, loans, and crypto, and that negative trends in ad demand strengthened from the second quarter to the third quarter.

Is this a red flag?

Advertising is a cyclical business, and in uncertain economic environments like the current one, it's often one of the first expenses that businesses cut back on, which makes sense. Companies anticipating a decline in consumer spending are likely to cut back on marketing, and digital advertising in particular can be easily ramped up or down according to demand. Cutting ad budgets also doesn't come with the baggage that laying off employees or slashing capital expenditures does.

Alphabet management seems to expect the headwinds to get worse before they get better. The company doesn't give guidance, but it said it expects stronger currency headwinds in the fourth quarter and plans to slow spending growth in the fourth quarter and in 2023, which should help shore up the profit decline.

After headcount jumped 25% to 187,000 year over year in the third quarter, CEO Sundar Pichai promised that employee additions would be significantly slower in the fourth quarter and in 2023. In Q4, the company plans to add less than half the new employees it did in Q3.

As a public company, Alphabet has been through two advertising cycles before. Both times, in the financial crisis and the coronavirus pandemic, advertising growth fell sharply but quickly rebounded as the economic climate improved, and that should be the case again. 

Google's advertising products are essential tools for a wide range of businesses, and it has a near monopoly on search, with around 90% in market share in the countries where it operates. Despite the decelerating growth, this is not a broken business by any means. 

Investors should expect slow growth over the next few quarters, as ad demand is likely to be weak, but Alphabet's strengths are still intact. Furthermore, the stock is reasonably priced at a price-to-earnings ratio of roughly 20 based on this year's estimates.

If the bear market persists, the stock could decline further, but for a dominant business and a profit machine, this isn't a bad entry point at all.

This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Jeremy Bowman has positions in Snap Inc. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Alphabet (A shares) and Alphabet (C shares). The Motley Fool Australia has recommended Alphabet (A shares) and Alphabet (C shares). The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.

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