Is Alphabet Stock a Buy After Its Post-Earnings Drop?

Shares of Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG) slid around 10% in after-hours trading on Wednesday, Oct. 28, after the Google parent released its third-quarter results. The sell-off came even though revenue grew 25% year over year to $127.6 billion and Google Cloud's revenue more than doubled.

But two other numbers looked worse. Earnings per share slid to $2.12 from $2.87 a year before. And free cash flow was negative for the second straight quarter, as capital spending rose to $51.4 billion -- over twice the year-ago total.

The drop puts the stock near $293 as I write, about 27% off its record close of $402.62 on May 13. I think the earnings decline looks worse than it is, but the cash flow is worth a closer look.

Image source: Getty Images.

Underlying profits still grew

Most of the decline in Alphabet's earnings per share had little to do with Google's operations. The company counts gains and losses on its stakes in other businesses as part of its earnings, and these swings can be big.

In the third quarter, an $8.7 billion loss on equity securities lowered earnings per share by $0.55, the company said. A year before, a $10.7 billion gain and related investment fees added $0.68.

Excluding both, earnings per share rose about 22% year over year, to about $2.67 from about $2.19.

Operating income, which leaves out these investment swings, climbed 30% to $40.6 billion. But last year's third quarter had a $3.5 billion charge for a European Commission fine. Without the fine, operating income grew around 17%.

Showing where the growth is coming from, Google Cloud's revenue climbed 103% year over year to $30.7 billion in the third quarter -- its sixth straight quarter of faster growth, after 63% and 82% in the first two quarters of the year. The unit's operating income roughly tripled to $11.1 billion. So Google Cloud turned about 36% of its revenue into operating profit, up from about 24% a year ago. And Alphabet's total revenue growth has quickened all year, to 25% from 22% in the first quarter.

Margins are sliding

Still, Alphabet's big spending on artificial intelligence (AI) is now showing up in its income statement. The company's operating margin dropped to 31.8% in the third quarter. It was 34% in the second quarter and 36.1% in the first. It was also under the 33.9% margin Alphabet reported a year ago, without the fine.

Depreciation on property and equipment, which grows when new data centers come online, jumped 49% year over year to $8.4 billion. And the costs Alphabet doesn't assign to a segment, mainly shared AI research, climbed to $7.7 billion from $4.5 billion.

Cash flow took a harder hit. Operating cash flow shrank 13% year over year to $42.3 billion, while capital spending grew 114%. Free cash flow was around negative $9.1 billion, after a negative $5.9 billion the quarter before. CNBC said that the third-quarter number also included a $5.2 billion payment linked to a 2018 European Commission fine.

For the last 12 months, Alphabet produced around $19.7 billion in free cash flow. A year before, the same number was around $73.6 billion.

To cover the gap, Alphabet has been borrowing and selling stock. Long-term debt hit $125.1 billion at the end of September, up from $46.5 billion at the start of the year. On top of that, the company sold around $12.4 billion in new stock during the quarter, and it didn't buy back any shares over the first nine months of the year.

And the spending isn't letting up. Alphabet held its 2026 capital expenditures outlook between $195 billion and $205 billion, which implies about $63 billion to $73 billion for the fourth quarter alone. Management also said it expects capital spending to grow significantly in 2027.

Is the drop a buying opportunity?

Shares now trade at around 19 times Alphabet's expected 2027 earnings. Before the report, they sold for about 21 times those earnings. For a company growing revenue 25% year over year, I'd say the stock is reasonably priced.

Of course, free cash flow will likely stay negative for at least another quarter or two. And Google services revenue rose 11%, slower than 15% in the second quarter, with Google Search & other up 12%.

But a segment that tripled its operating income in a year suggests the spending is already paying off.

Is that enough to make Alphabet stock a buy after the drop? I think so. At this price, I'd consider buying shares, though the cash flow might get worse before it gets better.

Daniel Sparks and his clients do not have positions in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet. The Motley Fool has a disclosure policy.