Is AI Killing Google's Golden Goose?

It's getting hard out there for the tech giants.

Just a week after Meta Platforms tumbled on its third-quarter earnings report, as otherwise strong results were overshadowed by negative free cash flow, investors wiped $500 billion in value from Alphabet (Nasdaq: GOOG) (Nasdaq: GOOGL) after the company disappointed in its earnings report, with the stock falling 12%.

The Google parent posted 25% revenue growth to $127.6 billion, but it wasn't enough to meet expectations at $127.9 billion. Still, 25% growth for a company of this size is impressive. Operating income rose from $31.2 billion to $40.6 billion, with operating margin ticking up from 31% to 32%. Generally accepted accounting principles (GAAP) earnings per share fell from $2.87 to $2.12 as the company reported other expenses of $8.2 billion, including a $12.4 billion loss on equity securities, primarily due to its investment in SpaceX, whose stock fell in the third quarter.

As a result, earnings per share missed the analyst consensus at $3.01, though investors should focus on the operating income figure.

Image source: Getty Images.

Why Alphabet stock tanked

Google Cloud posted its fastest growth on record, with revenue jumping 103% to $30.7 billion, but the gains were overshadowed by weakness in the core search business.

Revenue growth at Google Search rose 12% to $63.4 billion, marking its slowest growth rate since 2023, when digital advertising growth across the industry slowed amid a post-pandemic slump. However, this time around, macro factors don't seem to be a problem as Meta just reported 26% revenue growth to $63.1 billion, nearly equaling Alphabet's search revenue.

Instead, Alphabet seems to be struggling to continue growing search monetization at a time when queries are converting to AI mode, or users are going to other chatbot platforms like ChatGPT and Claude.

Management noted that queries experienced their fastest growth rate in five years, indicating the company is retaining adequate market share, and argued in favor of a holistic approach to search that connects AI mode and traditional search. It also said that AI mode would "create more monetization opportunities over time," indicating the company will likely increase ad load on AI mode. On the call, the company announced the expansion of ads in AI mode to international markets, as well as sponsored placements on follow-up questions in the U.S.

Management portrayed the slowdown in search as transitional as it ramps up ads in AI mode, and it also noted headwinds from foreign exchange. However, that was not enough to placate investors.

What's next for Alphabet

A 12% sell-off in Alphabet stock seems excessive given the strong growth on the top and bottom lines, but investors also seem to be reacting to the company's free cash flow going deeper into the red. Alphabet reported a $9 billion free cash flow loss in the quarter, reflecting the $195 billion-$205 billion it plans to spend on capex.

If search growth continues to slow, then today's sell-off seems justified, but I think it's too early to say that. Queries are growing rapidly, showing the company is in a strong position at the top of the funnel, and it knows how to make a digital advertising business work. Over time, the company should figure out how to make advertising work with AI mode as well.

In the meantime, 12% growth isn't a crisis, though investors are understandably worried about the trend. Alphabet doesn't give quarterly guidance, so we don't have a clear insight into the company's forecast, but the cloud business is delivering blistering growth.

If the company can stabilize search growth in the next few quarters, the stock is a good candidate for a rebound. I think that's more likely than not.

Jeremy Bowman 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.