Google Plunges After Ugly Top And Bottom Line Miss, As AI Cannibalizes Search And Ads
Today, ahead of the doubleheader of Mag 7 reports when both Microsoft and Google parent Alphabet report, we wrote in our preview that Microsoft has become the consensus long, while Alphabet "still feels like the consensus funding short across megacaps." And both have to convince a market that, as Goldman's Rich Privorotsky put it this morning, now has "eye watering expectations":
"These really matter. Eye watering expectations… buyside probably closer to Azure growth around high 40s%, Google Cloud around mid 90s%. The question isn't whether those are good numbers, but whether they can surpass already high expectations... Azure probably needs a guidance raise to be properly supportive. The nuance is capacity… if they miss elevated expectations simply because they cannot bring enough compute online. That's disappointing for near term revenue but potentially even more bullish for the scarcity premium and future spending. Watch customer concentration, how broad the demand really is and, crucially, the relationship between revenue growth, capex and margins. The market wants evidence that the incremental economics work."
In other words, a cloud beat is just the price of admission, and the debate tonight is what all that cloud costs, and who pays for it.
Within the Mag 7, Microsoft and Alphabet sit at opposite ends. Goldman's derivatives desk has Microsoft at 8/10 on its positioning score (the same score Meta carried into its print last week, and we all know how that went). Alphabet, meanwhile, keeps getting sold to pay for everything else. JPMorgan's TMT trader Brian Heavey wrote this morning that "we continue to see GOOG being used as a source of funds (note there was another negative 3P check ahead of earnings - all pointing to a Search miss)." The stock dropped 10% from its October 13 high into Monday.
There are some signs of a thaw. Goldman's US desk saw "a buyer of 50k GOOGL 15Jan 360 calls" on Tuesday, and Privorotsky notes that "people have barely begun to re-risk. What we've really seen so far is the abatement of supply, rather than meaningful fresh demand."
Away from Goldman, and focusing on Alphabet, the whole debate fits in one line from JPMorgan's Mark Schilsky, whose Tech Sketch "Earnings Preview Bonanza" (available to pro subs) frames it as "Street (Consensus) Fighter II: Search vs. Cloud":
"On the one hand, Google Cloud Revenues are likely to crush this quarter, thanks to TPU sales. On the other hand, Search Revenue growth is expected to miss the Street because the alt data (which is always right!) suggests so... GOOGL is also on a path to where Google Cloud Revenues could be equal to Search Revenues by late 2028. That's massive! Who thought that was possible 1 year ago? And now we're debating whether or not Search is going to miss by like -50 bps this quarter. Who cares?!?"
Plenty of people care, apparently. Schilsky gives Alphabet a 5 out of 10 on his investor expectations gauge, vs. a 9 for Meta last week:
Here is the buyside bar, combining Schilsky and the UBS bogeys:
- Search: investors expect ~14% growth, FXN and reported, vs. the Street's ~15%. UBS has the bogey at 14-14.5%. Goldman's analysts are 1% below consensus. Per Schilsky, "everyone 'knows' that Search is likely to miss by about -100 bps because that's where the alt data is," so "if this beats, the stock is almost assuredly going higher T+1." Watch paid clicks too (+13% in Q2), where "the comps get 3 points harder this print."
- YouTube: ~11-12%. "Honestly, no one really cares about YouTube. As long as growth doesn't dip below +10% Y/Y, investors will continue to ignore it."
- Google Cloud: this is where the buyside is way above the sellside. Schilsky hears +105% to +115%, UBS +100-115%, Goldman's analysts ~+100%, and Privorotsky's desk "mid 90s," all vs. the Street at roughly +90-96%. Implied TPU sales in the quarter: "most are in the $5B to $7B range."
- Operating income: ~$45 billion vs. the Street's ~$43 billion (UBS says $44-45 billion).
Note just how wide the range is on Google Cloud in Bloomberg's consensus: the median is $29.1 billion, but individual estimates run from $24.3 billion to $36.7 billion, roughly 60% to 140% growth. Elsewhere, Search is expected at $64.9 billion, YouTube at $11.4 billion, and total operating income at $43.2 billion. And look at the bottom line: consensus has Alphabet generating negative free cash flow of $3.5 billion this quarter, as $55.8 billion of capex swallows $53.9 billion of operating cash flow.
For Schilsky, the sneaky most important number is the Google Cloud margin: "given that this is the first quarter in which TPU sales are likely to be truly meaningful, any beat to the Street's ~33% EBIT Margin estimate will be rightfully viewed by investors as modest validation that TPU margins are close to – or possibly higher than – core Google Cloud Margins." Goldman's TMT specialists add the other side of that ledger: "Watch cloud margin commentary as they have flagged modest pressure... Search still funds the build. Any softness in search monetization or YouTube would compound the spend narrative."
Then there's the consumer agent. UBS says investors want two things before sentiment can inflect: "a credible AI agent that helps ease Muse/Search concerns, and a broader Gemini 4 rollout." Perceptions of Alphabet as a direct competitor to the leading frontier labs "have faded" after the latest Gemini delay (and after Gemini 4 Argon proved to be, well, benchmaxxed). Goldman's Eric Sheridan sees "an eventual consumer agent launch, possibly aligned with Gemini 4 ahead of the holiday season," and Schilsky expects "a 'real' competitor to META Muse in the coming months."
The $350 Billion Question
As always, the number that moves the stock may not even be in the quarter. Alphabet's 2026 capex guide sits at $195-205 billion, and UBS says the focus tonight is simply a reiteration. 2027 is another story:
- 2027 capex: Street ~$305 billion, per Schilsky. The buyside is at "$330B to $350B" (JPM) or "$350-375 bn" (UBS). Goldman's own estimate is $350 billion.
- 2028 capex: "Trust me, I've been asking investors for weeks for this number, but the most common answer I've received is a combination of 'Higher' and 'If anyone tells you with any certainty what their estimate for Google's 2028 is, they are b*#!$#!ing you.'"
- 2027 EPS: $14.50-16.00 per JPM, $15-16 per UBS, vs. the Street at ~$15. 2028 EPS is anyone's guess, with the "modal outcome" in the low $20s vs. the Street at ~$18.
- 2027 Google Cloud growth: the Street is at +68%, while "most investors are >+100% Y/Y."
So, a 70%-plus jump in capex to $350 billion or more is now the bull case. Recall what Sundar told us in July when the market balked at the last increase:
- *ALPHABET CEO: NEXT GEN FRONTIER MODELS WILL BE MUCH LARGER
With all that in mind (and it's quite a lot), here is what GOOGL reported moments ago, which judging by the negative stock reaction to the revenue and EPS miss a sign that the company is failing to generate enough return to justify its massive investments in AI, is a mirror image of the meltup after the stellar 2nd quarter, may explain why as noted above, GOOGL has been the funding short across the Mag 7 space:
- Revenue ex-TAC $111.21 billion, +27% y/y, missing estimates of $111.29 billion
- EPS $2.12 vs. $2.87 y/y, missing estimates of $3.03
Taking a closer look at the main segments:
- Revenue $127.58 billion, +25% y/y, missing estimate $127.93 billion
- Google Services revenue $96.30 billion, +11% y/y, missing estimate $98.4 billion
- Google advertising revenue $82.01 billion, +11% y/y, missing estimate $83.57 billion as AI is starting to aggressively cannibalize search and ad revenue
- Google Search & Other Revenue $63.35 billion, +12% y/y, missing estimate $64.85 billion
- YouTube ads revenue $11.21 billion, +9.2% y/y, missing estimate $11.43 billion
- Google Network Revenue $7.46 billion, +1.4% y/y, beat estimate $7.24 billion
- Google Subscriptions, Platforms and Devices Revenue $14.29 billion, +11% y/y, missing estimate $14.78 billion
- Google Cloud revenue $30.71 billion vs. $15.16 billion y/y, beating estimate $29.1 billion
- Other Bets revenue $372 million, +8.1% y/y, missing estimate $387.8 million
Other items:
- Hedging gains $194 million, estimate $21.1 million
- Total TAC $16.37 billion, +10% y/y, estimate $16.53 billion
- Operating income $40.58 billion, +30% y/y, estimate $43.16 billion
- Operating margin 32% vs. 31% y/y, estimate 33.7%
- Google Services operating income $39.16 billion, +17% y/y, estimate $40.53 billion
- Other Bets operating loss $2.05 billion vs. loss $1.43 billion y/y, estimate loss $1.72 billion
- Alphabet-level activities operating loss $7.66 billion vs. loss $4.47 billion y/y, estimate loss $5.49 billion
- Number of employees 204,757, +7.7% y/y, estimate 200,614
Last but not least, Capex:
- Capital expenditure $51.36 billion vs. $23.95 billion y/y, estimate $55.78 billion
Oops.
Here are the results visually:
Cloud was the only big beat. Google Cloud came in at $30.7bn vs $29.1bn expected (+103% y/y), but Search, YouTube, Subscriptions and Services all missed. Operating income of $40.6bn was 6% light.
Two speeds. Cloud doubled; Search grew 12% (vs the ~14% buyside bogey and ~15% Street), YouTube 9% (below the 10% line Schilsky said investors would tolerate), and Network just 1%.
Cloud margin jumped to 36.2% from 23.7%, well above the ~33% Street figure Schilsky flagged. But Alphabet-level losses rose 71% to $7.7bn and Other Bets lost $2.0bn, so about half of Cloud's $7.5bn profit gain went straight back out.
The cost of compute. R&D (+36%) and cost of revenues ex-TAC (+32%, where depreciation sits) both grew faster than revenue (+25%). G&A fell 17%, and headcount was still up 7.7% to 204,757.
Operating income was up 30%, but EPS fell 26% to $2.12. A $21bn swing in other income, including an $8.66bn net loss on equity securities, wiped out the operating gain. There was also a new $298mm preferred dividend line.
Capex rose 114% y/y to $51.4bn (below the $55.8bn consensus). Operating cash flow fell 13% y/y to $42.3bn, far short of the $53.9bn consensus, so the capex 'miss' did not help free cash flow.
Free cash flow was negative for a second straight quarter: -$9.1bn vs -$3.5bn consensus. Trailing-12-month FCF collapsed 73% to $19.7bn, from $73.6bn a year ago.
The funniest part is just how dramatic the Y-axis rigging was in the company's presentation to make the YoY growth better:
Some more comments from the press release:
- Model Apis Now Processing About 32B Tokens Per Minute
- Gemini App Has Reached 1 Billion Users
- Gemini App Has Reached Oneb Users—making
- Shares Drop 7% After 3Q Earnings Report
- Surpassed 150M Youtube Music & Premium Subs
- Gemini 4 Argon & Carbon Are Now Leading at Frontier
- 3Q Net Loss on Equity Securities $8.66B
- Google Cloud Rev. Grew 103%
- Surpassed 150M Youtube Music & Premium Subs Globally
We expect to hear much more on the call, including capex guidance: as a reminder, Google’s race to build AI infrastructure for both itself and its customers has sent its capital expenditures soaring to record levels. At the same time, the investments have helped Google evolve into a top supplier of computing power to AI companies including Anthropic PBC and Meta. The problem is that AI is now too successful, and is clearly cannibalizing from the company's core "bread and butter" advertising and search business, which missed badly across the board.
The company is also working to develop AI models itself and integrate them into consumer products such as the search engine, YouTube and Gmail - though those efforts have yet to pay off relative to the level of Google’s spending.
In response to the dramatic top and bottom line miss, GOOGL stock plunged 8%, not only reversing the July surge, but dragging the stock back to levels last seen in April as some 6 months of gains have been unwound.
Q3 Investor presentation linkl: