Alphabet's Cloud Business Just Doubled. The Stock Fell 12%. Is it a Buy?

Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG) reported third-quarter results after the market closed on Wednesday, and the stock fell about 10% in after-hours trading. At first glance, the reaction makes sense. Earnings and revenue both came in shy of estimates, and Alphabet is spending heavily on its AI build-out.

Having said that, the headline figures hide what I consider the most important part of the report.

Most of the miss was a paper loss

First, Alphabet recorded an $8.7 billion loss on equity securities during the quarter, which reduced earnings by $0.55 per share. CFO Anat Ashkenazi said the loss was driven primarily by Alphabet's investment in SpaceX (NASDAQ:SPCX), whose stock fell during the quarter. It's an unrealized loss, meaning Alphabet didn't sell anything, and the value of the SpaceX investment will likely swing from one quarter to the next for as long as the company owns it.

Image source: Getty Images.

Operating income, which excludes investment gains and losses, rose 30% to $40.6 billion. That's a better gauge of how the business performed, and by that measure it was a strong quarter.

Google Cloud is firing on all cylinders

The standout was Google Cloud. Revenue more than doubled to $30.7 billion, and this is actually the sixth consecutive quarter where Google Cloud's revenue growth rate accelerated. On the profitability front, cloud operating income jumped to $11.1 billion from $3.6 billion a year earlier, a margin of about 36%.

Perhaps most importantly, Google Cloud's backlog, which is revenue customers have committed to, but Alphabet hasn't recognized yet, reached $561 billion. That's up from $514 billion just three months earlier. For context, Google Cloud is on pace for about $123 billion in annual revenue, so its backlog is roughly four and a half years' worth.

The concerns are fair

To be sure, there are legitimate reasons for caution. Google Search revenue grew 12%, down from about 17% growth in the second quarter. Management blamed currency moves, softer retail ad spending in Asia, and lower monetization in AI Mode, Google's AI-powered search experience. That last one deserves attention, since investors want evidence that AI search can earn as much as traditional search.

Spending is the other major issue. Alphabet spent $51.4 billion on capital expenditures in the third quarter, mostly on AI infrastructure, and free cash flow was negative $9.1 billion. Management kept its 2026 capex forecast of $195 billion to $205 billion and said spending will "increase significantly" in 2027. Some analysts forecast spending of about $300 billion next year, and the numbers may be reaching the point where it's tough for investors to see the ROI potential. To help pay for the build-out, Alphabet sold $12.4 billion of stock and raised $28.7 billion in new debt during the quarter.

The bottom line

In short, Alphabet is investing heavily, and the payoff is most visible in Google Cloud. A business growing more than 100% per year, with a 36% operating margin and more than half a trillion dollars in committed future revenue, is exactly what I want to see from all that spending. But with spending expected to ramp up even further in 2027 and free cash flow already negative, investors don't seem convinced the company will achieve an attractive ROI on the hundreds of billions it is spending.

The biggest risk is that the spending cycle lasts longer than investors expect and that free cash flow remains negative as Search growth cools. I'll be watching both closely. But for patient, long-term investors, Alphabet trades for a historically attractive 21 times forward earnings, and could be worth a closer look after the decline.

Matt Frankel, CFP® has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet. The Motley Fool has a disclosure policy.