Alphabet’s ad business is slowing to a trickle. time to sell?

Enter alphabet‘s (WELL -9.63%) (GOOGL -9.14%) There were already signs that growth would be sluggish following Tuesday night’s earnings report for the third quarter.

Fellow digital advertising stock snap said revenue growth slowed to just 6% in the third quarter, and Alphabet management had earlier warned of macroeconomic uncertainty in its second-quarter earnings report.

Those fears were confirmed when Google’s parent company reported even worse-than-expected third-quarter results.

Revenue rose just 6%, or 11% in constant currency, to $69.1 billion, eventually missing estimates of $70.6 billion. Bottom line operating income fell 19% to $17.1 billion and earnings per share shrank to $1.06 from $1.40 in the year-ago quarter (below analyst consensus of $1.25- Dollar). The stock fell 6.6% after the close of business Tuesday night.

Advertising screeches to a halt

While Google Cloud and the projects in the Other Bets segment, like autonomous driving service Waymo, get some attention from investors, Alphabet is essentially an advertising company, and advertising makes up essentially all of its profits, as Google Cloud and other bets each lose year billions of dollars. Google search still accounts for a majority of the company’s revenue and profits, making it the number one determinant of the company’s success.

In the third quarter, search segment revenue rose just 4.3% to $39.5 billion, while YouTube’s revenue fell for the first time since the company published its results and fell 2% to just over $7 billion US dollar declined. Revenue from the Google Network, made up of Google ads on non-Google sites, also declined 1.6% to $7.9 billion.

Noting that the stronger dollar was partly responsible for the weak growth, management said the main reason for the weak performance was rapid growth in the quarter a year ago, when overall sales rose 41%.

However, Alphabet’s overall revenue also declined sequentially, and advertising revenue fell 3.2% to $54.5 billion in the second quarter, which is a clearer sign that macroeconomic headwinds are weighing on the business. On the conference call, the company said it saw a pullback in industries including financial services like insurance, credit and crypto, and that negative trends in ad demand intensified from the second through the third quarters.

Is that a red flag?

Advertising is a cyclical business, and in an uncertain economic environment like the current one, it’s often one of the first expenses companies cut, which makes sense. Businesses anticipating a drop in consumer spending are likely to scale back marketing, and digital advertising in particular can easily scale up or down based on demand. Nor does cutting advertising budgets come with the baggage of laying off employees or cutting capital spending.

Alphabet management appears to be anticipating the headwinds to get worse before they get better. The company doesn’t provide guidance but expects heavier currency headwinds in the fourth quarter and plans to slow spending growth in the fourth quarter and into 2023, which should help support the earnings decline.

After headcount rose 25% year over year to 187,000 in the third quarter, CEO Sundar Pichai pledged that hiring would be significantly slower in the fourth quarter and into 2023. In the fourth quarter, the company plans to hire less than half of the new employees it did in Q3.

As a public company, Alphabet has previously gone through two advertising cycles. Ad growth fell sharply during both the financial crisis and the coronavirus pandemic, but quickly rebounded when the economic climate improved, and it should be again.

Google’s advertising products are essential tools for a wide range of businesses and have a near monopoly on search, with around 90% market share in the countries where they operate. Despite the slowed growth, this is by no means a broken business.

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. Additionally, the stock is reasonably valued at a price-to-earnings ratio of around 20 based on this year’s estimates.

If the bear market continues, the stock could fall further, but for a dominant company and a winning machine, that’s not a bad entry point at all.

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 has positions in and recommends Alphabet (A shares) and Alphabet (C shares). The Motley Fool has a disclosure policy.

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