Alphabet’s third-quarter cloud revenue doubles, but AI expansion begins to squeeze cash flow

Why did net income fall despite growth in revenue and operating income?

Alphabet’s third-quarter revenue was 127.6 billion dollars, up 25% year over year; operating income rose 30% to 40.6 billion dollars, and the operating margin was 31.8%.
Net income and earnings per share fell year over year, mainly because other income and expense recorded a net expense of 8.2 billion dollars, primarily unrealized losses on its SpaceX investment as the company’s share price fell.
Costs are also rising: cost of revenues excluding traffic acquisition costs rose 32% year over year, mainly due to hardware costs associated with TPU system sales, depreciation, content acquisition and technical infrastructure operating costs.

Management said third-quarter search query volume grew at its fastest year-over-year rate in five years, and commercial queries were also growing; however, revenue from search and other advertising rose 12% year over year to 63.3 billion dollars, a slower rate than in the second quarter.
The company said exchange rates were the largest factor in the slowdown; some retail advertisers in Asia-Pacific were affected by the EU’s removal of its low-value duty exemption, and media and entertainment advertising spending returned to normal after the World Cup made the second quarter unusually strong.
Growth in AI Mode queries also affected revenue growth because they are monetized at a lower rate. The company said most AI Mode queries are incremental, and it is expanding AI search ads to more users and queries and entering international markets for the first time.
In the fourth quarter, search will also face a higher comparison base created by accelerating growth in the second half of last year; at current spot exchange rates, the company expects exchange rates to be a slightly greater drag on overall revenue growth than in the third quarter.

Google Cloud’s third-quarter revenue rose 103% year over year to 30.7 billion dollars, with AI infrastructure, AI solutions and core cloud services all driving growth, and TPU system sales also making a significant contribution.
Cloud operating income rose to 11.1 billion dollars, more than triple the year-earlier figure; the operating margin rose from 23.7% to 36.2%. But to ease tight computing capacity, the company began using third-party computing capacity at the end of the third quarter and plans to expand its use in the fourth quarter, with margins expected to come under pressure in the near term.
The cloud backlog stood at 561 billion dollars at quarter-end, and the company expects to recognize slightly more than 55% of it as revenue over the next 24 months. Management expects TPU system sales to continue expanding in the fourth quarter and revenue to rise significantly in 2027.

Third-quarter operating cash flow was 42.3 billion dollars, capital spending reached 51.4 billion dollars, and free cash flow was negative 9.1 billion dollars. In addition to capital spending, TPU system inventory buildup and payment of an EU fine of 5.2 billion dollars also affected cash flow.
TPU system sales involve a cycle in which investment precedes cash collection: after a contract is signed, the order enters the backlog, the company purchases components and builds inventory, and cash is collected after delivery and invoicing. Management said TPU inventory corresponds to signed contracts.
The company maintained its guidance for 2026 capital spending of 195 billion to 205 billion dollars and expects a significant increase in 2027; more technical facilities will also bring depreciation and data center operating costs.