Alphabet's Free Cash Flow Is Declining Faster Than Analysts Expected. Is This AI Stock Still a Buy?

Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG) stock fell sharply after the company reported its third-quarter results (ended Sept. 30), as investors processed several pieces of bad news. The first was that the company's search revenue of $63.4 billion was below analysts' consensus estimate of $64.5 billion. Fears that the company won't be able to monetize its AI Overviews as well as chatbots eating into its traditional search function weighed on its share price.

Worse yet, Alphabet reported negative free cash flow of $9.1 billion, far more than the $2.7 billion drop analysts expected.

Some shareholders viewed that information and immediately sold Alphabet stock. Here's why I think they're wrong and why it's a good time to pick up some shares amid the sell-off.

Image source: The Motley Fool.

Search revenue is important, but don't give up on the company just yet

Let's get the Search revenue disappointment out of the way first. Alphabet's Search sales rose by 12% from the year-ago quarter to $63 billion, but missed Wall Street's consensus estimates for the second consecutive quarter.

There are legitimate concerns that ChatGPT, Claude, and other chatbots could undermine the company's ability to monetize search results. But it's worth noting that all artificial intelligence (AI) companies are trying to figure out how to be profitable with their services right now, so this isn't a unique problem for Alphabet.

What's more, Alphabet said it now has 1 billion people using its Gemini app; that's up 54% from the same time last year. The company also said AI Mode searches are 3X longer than traditional searches. In short, Alphabet is adapting to AI, and I think it'll continue to figure out how to monetize artificial intelligence search in new ways as usage grows.

Soaring AI spending is paying off

Alphabet's negative free cash flow has everything to do with the company's surging spending on artificial intelligence infrastructure and little to do with its long-term profitability. What's more, $5.2 billion of the decline was due to a one-time cash payment for a European Commission fine.

Yes, the spending is very high. Alphabet's management said it will spend up to $205 billion in capex this year, mostly for AI. But focusing on at that amount, while overlooking the company's surging AI cloud sales, misses Alphabet's long-term prospects.

Google Cloud revenue spiked 103% to $30.7 billion in the quarter, and the company said it has $561 billion in backlog, more than half of which it expects to convert to revenue over the next two years.

That growth and large backlog of potential revenue show just how big Alphabet's AI cloud opportunity is. Google is the third-largest cloud player behind Amazon and Microsoft, with about 14% of the market, and is spending heavily now to maintain its position.

That's because AI cloud services are expected to be worth $2 trillion by 2030. To stay competitive in this space, Alphabet has to invest heavily on the front end to tap this market for years to come.

There's no guarantee of success, of course. But with cloud sales more than doubling in the quarter, shareholders should understand Alphabet is making big strides.

Alphabet is still an AI leader, and its stock is cheap

Alphabet's stock has a trailing price-to-earnings (P/E) ratio of just 14.7 right now, which is far below the tech sector average P/E ratio of about 24. By this metric, Alphabet stock is a downright bargain.

Does Alphabet have the best AI model with Gemini? Probably not. But does the company have a large user base, an established Search function that's evolving with AI, and a booming cloud business that benefits from artificial intelligence compute demands? Indeed, it does.

I think it's wise for investors to keep an eye on Alphabet's spending, and they should certainly watch for Google Cloud sales to continue rising as the company invests hundreds of billions in AI infrastructure.

But while the company's disappointing negative free cash flow isn't great to see, it shouldn't worry long-term investors because Alphabet is positioning itself now to continue tapping into the massive AI cloud market for years to come.

Chris Neiger has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, and Microsoft. The Motley Fool has a disclosure policy.