Alphabet spends more, grows less, and pays for it

Alphabet's shares fell 9.5 per cent in a single session after its third-quarter results, wiping $160 billion off its market value. Revenue beat forecasts. The trouble was Google Cloud, where growth slowed to 22.5 per cent while Microsoft's Azure was speeding up. Equity investors are in an unforgiving mood.

A tale of two clouds

Microsoft reported on the same evening, and the comparison was brutal. Azure's growth accelerated to 29 per cent in the September quarter, up from 26 per cent in the previous one, and Microsoft said artificial-intelligence services were contributing a growing share. Google Cloud had grown by 28 per cent in the April-to-June quarter, so its slowdown to 22.5 per cent came just as its larger rival was pulling away. For investors who had bought Alphabet partly as a play on cloud computing, the gap was the story.

Cloud matters more than its share of Alphabet's revenue suggests. Advertising still produces the bulk of the company's sales and nearly all its profit, but cloud is the business that investors expected to carry growth as search matures. It only recently became profitable, and a slowdown before it has reached scale raises the question of whether it can ever earn margins close to Microsoft's.

Scale makes the gap harder to close. Google Cloud is a distant third in the market behind Amazon Web Services and Azure, and in cloud computing the biggest providers can spread the cost of data centres and custom chips over more customers and offer lower prices. Corporate buyers also tend to consolidate their spending with fewer vendors, so a slowdown at the smallest of the three makes catching up more expensive.

Paying up for AI

Losing ground in cloud was only part of it. Investors realised that Alphabet is starting a heavy spending cycle to build generative AI infrastructure. Capital expenditure rose to $8 billion in the quarter, and management promised more. When heavy spending arrives just as growth slows in the high-margin cloud business, valuation multiples shrink fast.

The spending is largely on data centres and the specialised chips that train and run large language models. Since OpenAI's ChatGPT was released last November, Alphabet has been under pressure to show that it can match the product that Microsoft, as OpenAI's main backer, is weaving into its software and search engine. That means building computing capacity years ahead of the revenue it may one day produce. Depreciation on the servers will start to weigh on reported profits long before the returns are clear.

Why multiples shrink

The arithmetic of valuation explains the severity of the fall. A share price reflects the expected cash a company will return to its owners, discounted to today. Higher capital spending reduces free cash flow now, slower cloud growth reduces the expected cash later, and a higher discount rate reduces the value of both. All three moved against Alphabet in the same week, with the ten-year Treasury yield near its highest since 2007. Companies whose value depends heavily on distant profits are the most exposed to that combination.

The reaction was not unique to Alphabet. Meta's shares also fell after its results this week, and the technology-heavy Nasdaq index has fallen well below its summer peak. Investors who paid up for the largest technology companies earlier in the year on the strength of enthusiasm for AI are now asking when the spending will produce earnings.

What the bulls say

The case for Alphabet remains strong on paper. Search advertising grew by 11 per cent and YouTube advertising by more than 12 per cent, a solid recovery after last year's slowdown in digital advertising. The company is highly profitable, has a large cash pile and authorised $70 billion of share buybacks in April. Its researchers invented the transformer architecture on which most large language models are built, and it has its own AI chips, which reduces its dependence on Nvidia. On that view, the sell-off is an overreaction to one quarter of cloud figures.

Meta offers a precedent that cuts both ways. In 2022 its shares lost more than half their value as investors revolted against heavy spending on the metaverse while revenue growth stalled. Once management cut costs and growth returned this year, the shares recovered strongly. The lesson is that markets will punish open-ended spending until they see a return, and then reward it quickly once they do. Alphabet has not yet shown that return.

Risks beyond the numbers

There are also threats that no quarterly result will settle. The American Justice Department's antitrust trial over Google's search agreements, including its payments to Apple to be the default search engine on iPhones, began in September. A ruling against Google could weaken the distribution that underpins its advertising business. Generative AI itself may change how people search, reducing the number of queries that produce clickable ads. Alphabet is spending to defend its core business as much as to build a new one.

What to watch

The indicators that would change the call are Google Cloud's growth rate in the fourth quarter, any figures Alphabet gives on revenue from AI products, and management's guidance on capital spending for next year. Evidence that its Gemini model, which the company has said is coming, can compete with OpenAI's systems would help. So would a narrowing of the growth gap with Azure.

Alphabet's fall shows that investors will not pay for open-ended AI spending unless revenue growth speeds up soon. Until Google Cloud starts gaining on Azure, the shares will probably trade at a discount to Microsoft's, and that discount is likely to persist for at least the next two quarters.