The past few months have been a difficult time for technology companies focused on artificial intelligence.
Alphabet (NASDAQ: GOOGL), one of the largest of those companies, is a prime example. Its stock has dropped 14% since Oct. 28, when it issued a third-quarter earnings report that disappointed investors.
Its shares already had slumped since early May amid concern about the hundreds of billions of dollars Alphabet and its peers are spending on AI. The stock has dropped 28% over the past six months.
As for the earnings disappointments, while operating profit soared 30% year-on-year in the third quarter, to $41 billion, analysts expected $43 billion.
A big worry for investors is ad revenue, which accounted for 64% of total revenue. Ad revenue from Google Search rose 12% year-on-year, but that represents a deceleration from 17% expansion in the second quarter. YouTube’s ad revenue growth also decelerated – to 9% from 13%.
Analysts say that Google’s Gemini AI service may be cannibalizing Google Search, which at this point is more lucrative for ad revenue.
‘Moment of truth’
“This quarter feels like a moment of truth for Alphabet,” Thomas Monteiro, senior analyst at Investing.com, wrote in a report cited by Bloomberg. “Either [it] fixes the way it monetizes AI, or it risks losing its leadership in several of its core businesses in the near future.”
This is particularly important as Alphabet is on the hook for $1 trillion in future payments for data centers, computing, energy and other AI costs.
“Until Google shows it can charge for AI the way it once charged for search ads,” every capital spending forecast it issues is going to “read less like ambition and more like a bill,” Monteiro said.
All the AI spending already has pushed Alphabet’s free cash flow down year over year for the last two quarters.
But not everyone is so worried. When it comes to cash flow, “Alphabet isn’t a startup looking for profitability,” writes Barron’s Al Root. “It is spending on AI to build a new trillion-dollar business. If it shut off spending, free cash flow would return—but would investors really prefer that? Probably not.”
Meanwhile, the 12% gain in search ad revenue shows the business is “proving to be more resilient than many investors feared,” Morningstar analyst Malik Ahmed Khan wrote in a commentary. “We attribute this strong growth to AI overviews and AI-mode growing total search queries, as well as improving AI-driven ad targeting.”
Net-net winner
So AI continues to boost the company’s performance as a whole. Overall revenue surged 25% year-on-year in the third quarter, and the operating profit margin creeped up to 32% from 31% a year earlier.
Analysts agree that Alphabet’s cloud business, Google Cloud, is the biggest beneficiary of its AI effort. That unit delivered record revenue growth of 103% in the third quarter. Its revenue accounted for 24% of the company’s total.
“Not only is the segment’s growth stellar, its backlog is five times annualized quarterly sales, providing the business great visibility as it invests in AI infrastructure,” Khan said.
He’s impressed with Alphabet’s proprietary chips, tensor processing units (TPUs), which accelerate the company’s AI operations. They are a “key differentiator,” he said. “As Alphabet moves from renting out TPUs to actually selling them to external customers including Anthropic, and recently Oracle (NYSE: ORCL), we expect Google Cloud revenue to meaningfully inflect upward.”
Khan says investors “underappreciate” Alphabet’s AI monetization and the coming rapid growth for Google Cloud.
So maybe things aren’t really so bad for the company after all.
The author owns Alphabet shares.
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