To The Moon

$Alphabet(GOOG)$ fell 12.3% last week and are down 26.8% over the past six months. Yes, I sold about a third of my Alphabet shares in July based on valuation concerns and the company entering a phase of negative free cash flow. But I didn’t see this reaction coming.

I’ve been critical of a lot of the AI stocks out there because I think businesses like neoclouds are unsustainable and commodity suppliers like Micron will… commoditize. But Alphabet is king of the tech mountain and should be fine long-term.

Still, the market punished shares because there are signs of disruption. Search isn’t growing the way it was expected to, and that puts the cash flow to fund AI into question.

Here are my thoughts on the nuance and realities (both good and bad) at Alphabet.

Search is Fine. Not Great. Fine.

The reaction this week was mainly related to search and the deceleration of revenue growth. Keep in mind, there’s growth; it’s just slower than a year ago.

I don’t do estimates or pay attention to most analyst estimates, but the number I was looking for in earnings was search revenue growth AND that growth rate compared to YouTube.

We know YouTube is doing well as a business, so it shouldn’t be seeing weakness in ad revenue. So, if search is growing more slowly than YouTube, that would be a red flag.

But it didn’t! Search grew 12%, and YouTube grew 9%.

And that’s despite headwinds that management pointed to, like foreign currency, World Cup timing, and higher usage of AI mode, which isn’t monetized as well.

Let’s dig into that last point.

• Customers are using AI overviews/mode more

  • ie. Ten blue links are down; AI mode is up

  • Management said, “query growth rate is the highest it’s been in five years.” That may include Gemini and other tools, but it’s an indicator Google still has growing usage.

• AI mode isn’t monetized as efficiently as “ten blue links”

  • Duh!

  • Give it time.

• People use AI mode for longer conversations than search

If you’re worried about the disruption of search by chatbots, that’s not what we’re seeing, at least right now. Based on Google’s data, people are using AI mode more and more deeply than search. THIS IS GOOD!

Google is disrupting itself!

The tradeoff is, it’s not monetizing as well…yet.

I have to be honest, I thought this reason for the selloff was pretty uncompelling to a long-term investor. Search is fine. It’s growing double digits. And normies are using AI mode rather than a chatbot.

This isn’t a company in trouble.

Cloud Numbers Are Insane!!!

We can debate the future of search, but there’s no debate about the momentum of the cloud business. In Q3, cloud revenue was up 103%, and operating margin expanded to 36.2%.

A lot of this business is coming from Anthropic, but it’s also startups building on GCP and other businesses using the Gemini family of apps.

We are also seeing TPU sales in this segment, although Alphabet doesn’t break out TPU revenue or margins. But I also see TPU sales as a great diversifier for the cloud business. It makes Google Cloud more of a platform for companies to build on and brings competition to NVIDIA, which otherwise would be a huge cost for the AI buildout.

Capex Is…High

Speaking of capex, the numbers here are getting crazy. $51.4 billion in capex in Q3, and that’s going to go up in Q4.

There are also commitments to spend nearly $1 trillion in the future, most of that related to capex and the cloud business.

At the end of the third quarter, we had future purchase commitments of $924 billion in pre-commencement leases and other obligations of $152 billion. These dollar amounts reflect the maximum contractual obligations. However, a number of these agreements have variable pricing and volume flexibility, which could result in lower spend.

Anat Ashkenazi, CFO

The spending is driving Google Cloud, which I mentioned is growing like crazy, but it’s also putting the company in a position where it’s burning cash. Free cash flow was negative in both of the last two quarters, and based on Q4 capex expectations, that’s likely to get worse.

This is what the market is worried about. Is there a payback to all of this spending?

• If search isn’t the never-ending cash cow the market thought it was, there could be more pressure on the balance sheet.

• 103% growth in the cloud is great, but is that enough to justify all of this spending?

Those are valid questions that the market is asking right now. And it’s asking this of all players in the AI buildout.

The good news is, Alphabet is in a stronger position from a balance sheet, technology, and distribution standpoint than most competitors.

The Bottom Line

Let’s not forget what Alphabet has going for it right now.

1. The core search and other businesses generated $180 billion in operating cash flow over the past year.

2. Alphabet has $265 billion in cash on the balance sheet.

3. Google makes some of the best models in AI, has one of the biggest clouds, and makes some of the best chips.

4. Alphabet owns ~$100 billion stakes in both SpaceX and Anthropic.

The market’s reaction this week was big, and it’s understandable if you think search is being disrupted right now. But I don’t think that’s the case, and a vast majority of people still use the search bar for all queries, even if they use the AI tools.

In short: Usage appears to be strong. Better monetization of AI mode will take time.

As much as I’m concerned about huge capex and future obligation numbers, part of the thesis behind owning Alphabet is that they’ll use the core business and balance sheet to bludgeon the competition in AI. That’s what we’re seeing today.

In time, I think Alphabet will come out just fine, and the stock looks closer to an opportunity than a threat. If we get a P/E multiple of ~15x like we had when I opened this position, I will be happy to add more.