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Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL) just delivered a mixed third-quarter earnings report. Revenue increased 25% year-over-year to $127.6 billion, while Google Cloud more than doubled its revenue. However, the company also reported negative free cash flow of $9.1 billion, raising concerns about its enormous artificial intelligence investments.
Its shares fell sharply following the announcement. But should investors be worried about the company's financial position, or is this simply the cost of building its next growth engine?
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Here are three things investors should understand before making the next move.
Perhaps the biggest concern from the latest earnings report is Alphabet's free cash flow.
The company generated $42.3 billion in operating cash flow during the third quarter. However, it spent $51.4 billion on capital expenditures, resulting in negative free cash flow of approximately $9.1 billion.
This is the second consecutive quarter of negative free cash flow, marking a significant change for a company historically known for generating substantial cash.
The main reason is its aggressive investment in AI infrastructure. Alphabet is building data centers, purchasing servers and networking equipment, and expanding its computing capacity to support growing demand for AI services.
However, there are other factors worth understanding. Alphabet is also building inventory for its custom Tensor Processing Unit (TPU) systems, which it sells to customers. This requires the company to purchase hardware before receiving payment. Additionally, it made a $5.2 billion payment related to a 2018 European Commission fine during the quarter. These factors further affected cash flow.
Importantly, Alphabet generated $179.6 billion in operating cash flow over the trailing 12 months, and trailing 12-month free cash flow remained positive at $19.7 billion thanks to strong cash generation in earlier periods. It also ended the quarter with $265.1 billion in cash and marketable securities, although this includes $90.4 billion of equity investments.
In other words, the company isn't facing an immediate liquidity problem. But investors should pay attention if heavy investments continue to consume more cash, further draining liquidity in the coming quarters.
Despite the disappointing earnings announcement, Alphabet's operating performance remains impressive.
Revenue increased25% to $127.6 billion, while operating income grew 30% to $40.6 billion. Operating margins also improved to 32%.
Google Cloud was particularly strong, with revenue more than doubling to $30.7 billion. Its operating income reached $11.1 billion -- more than tripling year-over-year -- demonstrating that the business is becoming an increasingly important contributor to Alphabet's profits. Its backlog also reached $561 billion, reflecting strong demand for cloud computing and AI services.
Meanwhile, despite concerns about the traditional Google Search business, revenue for this segment increased 12% to $63.4 billion. However, this remains an area worth monitoring as the company evolves its search business due to the rise of generative AI.
Taken together, these numbers suggest that Alphabet's business isn't deteriorating. Its cloud business is expanding rapidly, while its advertising business continues generating substantial revenue.
The bigger challenge is whether AI strengthens its existing businesses rather than undermining their profitability over the longer term -- an area investors should closely monitor.
Alphabet is investing heavily to capture a potentially enormous AI opportunity. If these investments generate attractive returns, today's spending could support years of future growth.
However, investors shouldn't assume that every dollar spent on AI will eventually pay off. There are three things worth monitoring.
First, watch whether Google Cloud can sustain its growth while maintaining healthy profit margins. Its latest results are encouraging, but investors need to see continued profitability.
Second, monitor Search advertising growth. If AI-powered search attracts more users but generates less advertising revenue, it could weaken Alphabet's most important cash-generating business.
Finally, pay attention to free cash flow. Alphabet needs to demonstrate that its enormous infrastructure investments are translating into additional profits and cash generation.
Alphabet remains a powerful technology business with leading positions in search, digital advertising, cloud computing, and artificial intelligence.
Its latest results don't suggest that its core business is falling apart. Revenue and operating income are still growing, while Google Cloud is emerging as another important growth engine.
However, the investment proposition is changing. Investors must now consider whether Alphabet can turn its enormous AI investments into attractive returns while protecting its traditional advertising business.
For existing shareholders, one disappointing quarter isn't necessarily a reason to sell. But it is a good reason to reassess the investment thesis.
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Lawrence Nga 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.
Alphabet's Free Cash Flow Just Turned Negative. Should Investors Sell the Stock Now? was originally published by The Motley Fool
