The Weekend Edition is pulled from the daily Stansberry Digest.
Alphabet had plenty to brag about...
Alphabet (GOOGL) reported third-quarter results on Wednesday night. CEO Sundar Pichai opened the call with good news...
The company is now at "a half a trillion-dollar annual run rate" in sales, he said.
Google Cloud revenue more than doubled from a year ago, to about $30.7 billion. Search queries are growing at their fastest pace in five years. Gemini AI surpassed 1 billion monthly users and "token" use is up 40% from the prior quarter.
And demand for the company's broad AI products is so strong, Google can't keep up with it – for better or worse.
Chief Financial Officer Anat Ashkenazi said that because of the "supply-constrained environment," Google started renting computing capacity from third parties at the end of the quarter – and will lean on that more over the next three months.
But Alphabet's AI-related spending plans aren't slowing down. Ashkenazi reiterated that Alphabet expects its capital expenditures ("capex") to "increase significantly" in 2027. Wall Street is penciling in more than $300 billion.
So why did the stock fall nearly 13% after its report?...
For a second straight quarter, Alphabet spent more than it brought in.
This isn't an overnight story. Regular readers know the cash-rich "hyperscalers" have been turning into capital-intensive businesses by betting on AI and spending on infrastructure like data centers, chips, and energy.
Now it's showing up on balance sheets.
In the third quarter alone, Alphabet spent about $51 billion on capex. Its businesses brought in about $42 billion in cash. That left free cash flow at negative $9.1 billion... much worse than the roughly negative $2.7 billion analysts expected. And that followed negative $5.9 billion last quarter.
A few factors contributed to that result. But the biggest is probably how Alphabet is approaching the AI build-out.
Mainly, it has been stockpiling its own tensor-processing-unit ("TPU") chip systems before it sells them to customers like Anthropic, Oracle (ORCL), and reportedly OpenAI and Meta Platforms (META).
Ashkenazi spun that approach as "a different cycle of cash flow generation." In other words, cash goes out first and comes back later when customers (presumably) pay.
Maybe that all happens and works out great for everyone involved. Meanwhile, Alphabet is looking for more cash now to keep building...
That's why the company sold $28.7 billion in bonds and another $12.4 billion in new stock last quarter. It also stopped its share buybacks for the year. Yet, it has also agreed to pay more than $900 billion in future purchase commitments for computing capacity, equipment, energy, and more.
Put it together, and Alphabet shares saw their biggest one-day loss ever on Thursday, falling 12.7%. The stock is trading at its lowest level since March... and is about 30% off its all-time high in May.
A Magnificent Seven peer fared much better with a similar (but importantly different) story...
Microsoft (MSFT) also reported its earnings on Wednesday. But its shares fell just 0.1% the following day.
The firm reported $45 billion of capex in its fiscal first quarter. That's less than the "over $50 billion" it had alluded to in July.
But here's the important part: It produced about $18.6 billion in free cash flow.
There are two big reasons why...
- Microsoft sells most of its new AI capacity to corporate customers under signed contracts before it's built. Its backlog of contracted commercial revenue hit $677 billion, up 73% from a year ago.
- Last quarter, Microsoft stretched the assumed life of its data centers from 15 years to 25 years. That shifted many future leases from "finance" leases, which count as capex, to "operating" leases, which don't.
The spending didn't change, but the headline capex number got smaller. That accounting decision helps Microsoft say it expects to stay free-cash-flow positive for the full fiscal year.
Still, it is spending more than $50 billion this quarter – and not entirely out of its own pockets. Bloomberg reported this week that Microsoft is preparing its first U.S. bond sale since 2017 to raise at least $25 billion.
But even though Microsoft and Alphabet have similar spending stories, Alphabet is the one that got punished.
It's because of reported cash flow... or lack thereof.
Wall Street Wants More Than AI Ambitions
This is becoming a more consistent theme for the market winners and losers...
Last week, when Meta reported negative free cash flow for the quarter, its shares fell 7%. Three months ago, when Microsoft, Alphabet, and Meta reported earnings, the market reached a similar "split decision."
Given Alphabet's weight in the cap-weighted market indexes (nearly 9% in the Nasdaq Composite Index and around 5% in the benchmark S&P 500 Index), the whole market felt the outcome of its post-earnings slide.
On Thursday, the Nasdaq was down 1.4%, and the S&P 500 was about 0.3% lower – despite more than 400 of the index components seeing gains and the equal-weight S&P 500 being up more than 1%.
So what does it all mean?...
Well, despite the noise around Alphabet and Microsoft, AI spending isn't stopping. In fact, it's still exceeding expectations.
Microsoft will spend more than $50 billion on AI-related investments this quarter, and Alphabet says its spending will rise significantly next year.
What's changing is who gets rewarded for spending and how. A year or two ago, any company that announced a bigger AI budget got a pop in its stock.
Today, the market is demanding more answers, like "Can you afford it?" and "What's your payoff?"
Businesses that are funding AI build-outs with borrowed money and new shares will be more sensitive to market forces and risks – like interest rates or the prospects of other companies in AI's "circular" world.
But so long as these businesses are finding financing, it might not matter. Microsoft, for example, reportedly has already attracted $115 billion for the $25 billion bond sale we mentioned earlier.
Notably, on Thursday morning, the government reported that real gross domestic product ("GDP") rose at a 3.4% annual rate in the third quarter, up from 2.2% in the second quarter. Many forecasters had been looking for something closer to 3%.
A large amount of that growth came from AI-related investments, which contributed about 1.78 percentage points, or roughly half of all U.S. economic growth, last quarter.
Whitney Tilson calls the AI sell-off a "hiccup"...
Our colleague Whitney Tilson has been warning that the AI boom has turned into a bubble that's starting to leak. But while some companies will get clobbered, others will survive and even thrive.
On Wednesday morning, Whitney sat down on camera with Silicon Valley insider Jeff Brown, the founder of our corporate affiliate Brownstone Research, for a new free presentation to discuss where they see the next leg of the AI opportunity.
Their focus was on what they call an AI "super chip" – a new design that is 50 times faster than Nvidia's (NVDA) chips... the tiny California company behind it... and five little-known stocks they've dubbed the "Fabulous Five." Together, they believe these names could hand investors 10 times their money.
If you're eyeing chip stocks after their recent slide, these are the kinds of opportunities to consider.
All the best,
Corey McLaughlin
Editor's note: The last time Whitney and Jeff gave away a free pick together, it quadrupled in a little more than a year. Now, the two financial legends are back with two free investment ideas. With AI stocks becoming more volatile, they believe these opportunities could help investors position themselves for the market's next big move.
