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Alphabet (NASDAQ: GOOGL) (NASDAQ: GOOG) is arguably best known for its internet search and digital advertising business. Its dominance is one of the primary reasons I identified Alphabet as my top "Magnificent Seven" stock to buy at the beginning of the year.
Google Cloud has always been an important part of the business, but it wasn't the main attraction. Artificial intelligence (AI) is changing that equation.
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During Alphabet's third-quarter earnings call, CEO Sundar Pichai revealed that Google Cloud revenue surged 103% year over year. "Our AI infrastructure and solutions are the major drivers for Cloud growth and our customers see us as the leading provider here, so there's huge demand," he said.
That's an impressive number for a business operating at Google's scale. And it raises an interesting question for investors: Could Google Cloud become an even bigger reason to own Alphabet stock?
Alphabet reported Google Cloud revenue of $30.7 billion in the third quarter, slightly more than double the $15.2 billion it generated in the same period last year. But the revenue growth is only part of the story.
Google Cloud's operating income more than tripled to $11.1 billion, while its operating margin expanded from 23.7% to 36.2%. That's a remarkable improvement for a business that has historically operated with much thinner margins than Google's advertising operations.
Google is benefiting from its ability to offer customers a range of products from AI infrastructure to its Gemini models. It also designs its own Tensor Processing Units (TPUs), specialized chips built to handle demanding AI workloads.
These chips are becoming an increasingly important part of Google's business. Alphabet said TPU system sales made a meaningful contribution to third-quarter revenue growth, giving the company another way to profit from the enormous investments businesses are making in AI.
But there's an even more interesting number buried in Alphabet's earnings report.
Google Cloud ended the third quarter with a whopping $561 billion in backlog, representing contracted revenue that hasn't yet been recognized. That's a massive amount of business already under contract, and management expects to recognize just over 55% of that backlog as revenue over the next 24 months.
For investors, the backlog provides some visibility into Google Cloud's future revenue. It also suggests that the company's recent growth isn't simply the result of customers experimenting with AI. Businesses are making substantial financial commitments to Google's infrastructure.
And Google has another advantage. Unlike many AI infrastructure providers, Alphabet can support its enormous investments with an established, highly profitable advertising business.
Google Services generated $96.3 billion in third-quarter revenue, an 11% increase from a year earlier. Search and other advertising revenue grew 12%, providing additional evidence that AI hasn't undermined Google's core business.
In fact, Pichai said AI is contributing to increased search activity, with year-over-year query growth reaching its highest rate in five years.
That's an encouraging combination: Google's traditional business continues to grow while Cloud becomes an increasingly important source of revenue and profits.
Building enough computing capacity to satisfy customers isn't cheap. Alphabet's capital expenditure bill was $51.4 billion in the third quarter, and the company reported negative free cash flow of $9.1 billion.
Alphabet is also relying on third-party computing capacity to help meet demand. CFO Anat Ashkenazi warned that this arrangement could pressure Google Cloud's operating margins in the near term. That's something investors shouldn't overlook. Google Cloud's revenue growth is outstanding, but the company must continue investing heavily to deliver on its commitments.
The backlog is encouraging, but it doesn't guarantee that every dollar of future revenue will translate into profits.
The company is spending heavily on AI, but it's necessary spending. Alphabet's future largely depends on its ability to incorporate AI into its offerings and to offer world-class cloud computing services.
Google Cloud is growing rapidly, generating substantial operating profits, and accumulating an enormous backlog of contracted business. Meanwhile, Google's advertising operations continue to provide the financial muscle needed to support its AI investments.
Pichai's announcement gives shareholders something tangible to celebrate. Google's investments are paying off in a tangible way -- and Google Cloud's backlog suggests there's plenty more business waiting to be delivered.
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Patrick Sanders 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.
Sundar Pichai Just Delivered Stunning News About Google Cloud was originally published by The Motley Fool
