Google Cloud Revenue Just Grew 103%, so Why Is the Stock Falling?

Amid uncertainty about the future of artificial intelligence (AI), Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG) sought to address investor fears when the company reported its quarterly results after the market close on Wednesday.

What became immediately apparent is that while relentless demand for AI continues to drive rapid cloud growth, Alphabet is investing heavily to capitalize on that opportunity at hand. Investors viewed falling profits as the canary in the coal mine -- but the devil is in the details.

Image source: The Motley Fool.

Partly cloudy

For the third quarter, Alphabet's revenue jumped 25% year over year (15% in constant currency) to $127.6 billion. The company's operating margin ticked higher to 32% from 31%, driving operating income up 30% to $40.6 billion. Unfortunately, diluted earnings per share (EPS) of $2.12 dropped 26%, but that requires context -- more on that later.

Analysts' consensus estimates called for revenue of $127.9 billion and EPS of $3.01, so Alphabet failed to meet Wall Street's expectations on both counts.

Google search and the related advertising represent the vast majority of Alphabet's revenue. Investors have expressed concerns that broad advances in AI could siphon away advertising revenue, but those fears appear overdone -- at least for now. Google's search revenue climbed 12% year over year, partially offset by weakness at YouTube, which grew about 9%. In all, Google ad revenue grew 11%.

Speaking of AI, Google's cloud results have become of particular interest to investors, as they are viewed as a proxy for its AI success -- and business is booming. Google Cloud revenue soared 103% year over year to $30.7 billion and marked an acceleration from 82% cloud growth in Q2.

CEO Sundar Pichai noted the cloud results were "powered by huge demand for our AI infrastructure and AI solutions." He went on to say the company was seeing strong demand for Google's flagship Tensor Processing Units (TPUs) -- its homegrown AI-centric semiconductors.

Most telling was the segment's operating margins, which climbed to 36.2%, up from 23.7% in the prior-year quarter and 35.6% in Q2. This shows that Google Cloud is leveraging its assets and driving greater profits.

Given the magnitude of its cloud growth, it should come as no surprise that Alphabet is increasing investment in its cloud and AI. The company expects capital expenditures (capex) spending of roughly $200 billion in 2026, before climbing to $300 billion in 2027. Alphabet's heavy capex spending is weighing on its cash generation, with free cash flow of -$9.1 billion.

The devil is in the details

Alphabet stock took it on the chin, falling as much as 11% in after-hours trading. Investors focused primarily on declining profits, as EPS fell 26%. However, that stands in stark contrast to the company's increasing operating income, which rose 32%. So what gives?

The answer is found in Alphabet's other income and expense line. The company's portfolio of equity investments, which includes Space Exploration Technologies, aka SpaceX, and more than two dozen others -- declined in value in the third quarter. These investments lost $8.2 billion in all, compared to gains of nearly $12.8 billion in the prior year quarter. That represented a hit to the bottom line of nearly $21 billion. Without that swing, Alphabet's net income would have increased by 35%.

Despite the stock price plunge in after-hours trading, the evidence is clear. Google Cloud grew 103%, illustrating that its AI and cloud strategy is paying off. And Alphabet is selling for just 16 times earnings -- near the stock's lowest multiple ever.

That's why Alphabet stock is a screaming buy.

Danny Vena, CPA has positions in Alphabet. The Motley Fool has positions in and recommends Alphabet. The Motley Fool has a disclosure policy.