Alphabet (NASDAQ:GOOG) is a giant in the digital advertising sector, and it benefited tremendously from the COVID-19 pandemic (in the era of free money – zero interest rate environment). Digital ad spending in the United States increased from $152.7 billion in 2020 to $211.2 billion last year. And this year, US digital ad spending is expected to hit $240 billion, continuing to expand rapidly for many years to come. After falling about 33% year-to-date, Alphabet stock is very cheap.
US Spending on Digital Advertising
While these market projections have not been revised downward (yet), the shift in tone from digital advertising bellwethers such as Meta Platforms (NASDAQ:META), Roku (NASDAQ:ROKU), and Alphabet has raised concerns about the status of global economies and the near-term prognosis for the digital advertising sector. With central banks worldwide implementing quantitative tightening programs to combat high inflation, asset valuations are falling across the board, and an economic recession is becoming more likely by the day.
Businesses will reduce ad spending in response to an impending recession, damaging Alphabet and others. Despite the ad giant’s cost-cutting attempts to increase profitability, the stock is falling as trading multiples contract to all-time lows. While rising interest rates force this value adjustment, the next leg is more likely to be driven by fundamental factors.
Alphabet Stock is Now More Affordable than Ever
The advertising market shrank by 25% during the Great Financial Crisis of 2007-09; nevertheless, low penetration levels allowed digital advertising companies to expand during this time. This time, digital advertising accounts for the vast majority (60-65%) of the total advertising pie. As a result, a drop in ad spending is expected to hurt digital advertising firms.
Alphabet is one of the world’s most powerful corporations, and its monopolistic dominance in ‘Search’ is evident. While Alphabet will continue to generate billions of dollars in revenue (and free cash flow) in the coming years, a 15-20% decline in advertising dollars will result in significantly weaker operating results for Alphabet, which is not immune to the poor macroeconomic environment and the broad digital advertising markets.
Alphabet Stock Weakness Is Temporary, but the Moat Is Permanent
Historically, businesses (big, medium, and small) cut back on advertising spending during recessions, and Alphabet’s Q2 earnings indicated early indicators of a significant slowdown in digital advertising. Along with a substantial slowing in revenue growth rates, Alphabet is also facing a moderation in operating margins. Advertising rates tend to fall during recessions, and Alphabet’s margin profile may suffer in the coming quarters.
As the digital advertising behemoth deals with a challenging macro climate, Alphabet’s management team has implemented many cost-cutting initiatives, the most recent of which was the termination of Stadia, a consumer gaming service. Sundar Pichai, Alphabet’s CEO, has been sounding the alarm about the economy and rising competition in recent weeks (from TikTok). Looking at Alphabet’s cost-cutting strategies, I believe he is serious about striving for a 20% increase in operating efficiency to help the company weather this slump. We’re still in “Hiring Freeze” mode, but I wouldn’t be surprised if some layoffs occurred in 2023. Alphabet experienced hypergrowth during (and immediately following) the epidemic and went on a recruiting frenzy. The music, however, has stopped, and Alphabet may need to sit down (like Meta Platforms, where restructuring is rumored to be in the offing).
Pain is on the way, and Alphabet is no exception to the changing macroeconomic landscape. On the other hand, thanks to its great business moats, Alphabet will continue to dominate the digital advertising market on the other side of this recession. Alphabet’s Search and YouTube assets are the most frequented websites in the world as of August 2022, and these eyeballs aren’t going anywhere. They were there before the recession will be present during the recession, and will be present after the recession.
Alphabet’s primary business is advertising, but it is also a cloud hyperscaler, productivity software supplier, and much more. While evaluating the monetization potential of extremely useful goods like Google Maps is difficult, I am confident that Alphabet could easily generate an extra multi-billion dollar revenue stream through Maps, and the inclusion of immersive views is likely a step in that direction. My point is that Alphabet still has a lot of room for future expansion.
Nobody knows how deep or how long the economic downturn will persist, but Alphabet’s cash buffer of $125 billion (compared to long-term debt of only $15 billion) is highly reassuring. I think Alphabet is well-capitalized to weather the storm and expand its market position during this turbulent moment [through savvy acquisitions such as Mandiant]. We’ve already established that Alphabet stock has never been cheaper regarding trading multiples.
Alphabet Stock Market Value and Expected Returns
An economic downturn is on the horizon, and Alphabet stock multiples could drop further. I have no idea where the bottom is, and I refuse to speculate. The eventual bottom will be determined by how deep the recession is, and we will only be able to recognize it in retrospect.
Regulators continuously scrutinize Alphabet’s monopolistic dominance in the advertising sector. As you may know, Alphabet has a history of multibillion-dollar fines, and privacy worries persist.
The regulatory danger of an enforced breakdown of its advertising ecology is always present, and it is sufficient to keep its trading multiples low for extended periods.
Alphabet is significantly reliant on its primary advertising business, and despite billions of dollars invested, none of its different efforts (cloud, gaming, and “Other Bets”) have proven profitable.
Alphabet is a multinational corporation, and currency fluctuations harm its bottom line. While higher interest rates in the United States will offset some of these losses, Alphabet’s results may continue to suffer due to an impending de-globalization trend.
Should You Buy Alphabet Stock?
Alphabet is a digital advertising giant but is not immune to the macroeconomic environment. Alphabet’s financial performance will suffer as the advertising market declines. As a result, Alphabet is entering a turbulent moment. To its credit, Alphabet is full of cash, and interest in its core digital businesses – Search and YouTube – remains high. And Google Cloud is rapidly expanding. A recession will come and go, but Alphabet will not.
While Alphabet’s stock may suffer further in the short term, it has never been cheaper in its entire trading history. Alphabet has a 25-30% loss risk in the immediate to medium term and a 200% upside risk over the next five years based on present levels. As a result, Alphabet stock is an asymmetric contrarian play for risk-taking long-term investors.
Featured Image – Megapixl © Vladsseven
