Alphabet Inc. Class C (GOOGL.US) Q2 cloud revenue soared 82%, but capital expenditure is set to skyrocket to $205 billion, scaring the market with negative cash flow for the first time ever.

On July 22nd, after-market, Alphabet Inc. Class C's parent company, Alphabet (GOOGL.US), announced its second quarter financial report for 2026. Despite the strongest growth ever in its cloud computing business, the company raised its annual capital expenditure guidance for 2026 to a maximum of $205 billion and reported its first-ever negative free cash flow for a quarter, alongside delays in its flagship AI model Gemini 3.5 Pro, causing the stock price to drop nearly 5% in after-hours trading. The financial report showed that Alphabet achieved total revenue of $119.8 billion in the second quarter, a 24% year-over-year growth, exceeding market expectations of $116.9 billion. Total sales, excluding partner revenues, were $103.6 billion, also higher than analyst expectations of $101.07 billion. However, there was a divergence in profitability. Due to a significant increase in investment valuations in its portfolio (including holdings in companies like Anthropic and SpaceX), the quarterly investment income increased by close to $100 billion, driving GAAP net profit to $9.11 per diluted share, well above Wall Street estimates. However, excluding investment income and other non-recurring items, adjusted earnings per share were $2.85, slightly below market expectations of $2.89. This discrepancy in profitability, coupled with soaring capital expenditures, left investors uneasy. Massive capital expenditures result in negative free cash flow The most concerning issue for the market was the unexpected increase in capital expenditures. CFO Anate Ashkenazi announced during the analyst call that the company expects annual capital expenditures for 2026 to reach $195-205 billion, a significant increase from the previous guidance of $180-190 billion in the last quarter, and well above Wall Street's previous estimate of around $186 billion. She also reiterated that capital expenditures for 2027 would also increase significantly. In fact, Ashkenazi had already warned in April that spending in 2027 would increase significantly, causing analysts to revise their expectations upwards. According to FactSet data, analysts now expect capital expenditures for 2027 to be around $257 billion, with Evercore analysts even suggesting $262 billion in their recent report, jokingly questioning whether it would reach "300 or 350 billion?", while expressing concerns that the final expenditure could be even higher than their forecast. The high spending directly eroded cash flow. Although the company achieved $39.1 billion in operating cash flow for the quarter, free cash flow was negative $5.9 billion, marking the first time in history that Alphabet had a negative free cash flow for a quarter. Investing.com's senior analyst Thomas Montero commented, "After experiencing a quarter of negative cash flow, Alphabet has once again raised capital expenditures, which has made the market uneasy. The market's most reliable cash creator is now spending more than it earns. As long as revenue continues to accelerate, investors may be able to tolerate this, but capital expenditures now have real costs, and the margin for error is shrinking every quarter." Ashkenazi explained that over the past three years, the company had significantly expanded its AI infrastructure capacity, but "market demand still exceeds our investment," and some capacity deliveries were faster than expected, leading to the adjustment in expenditure plans. In just the second quarter, Alphabet's capital expenditures amounted to $44.92 billion, slightly exceeding market expectations of $44.15 billion, with "a vast majority" dedicated to AI technology infrastructure. Approximately 60% of the infrastructure investment was used for servers, and 40% for data centers and network equipment. Given the continuous constraints on capacity supply, Ashkenazi also announced a new strategy: "We plan to expand the use of third-party cloud capacity in the third quarter as a transitional solution during the internal capacity enhancement period." This strategy builds upon Alphabet's existing GPU rental agreement with SpaceX, where the company currently pays SpaceX $920 million per month to use NVIDIA Corporation's GPUs to run AI models. CEO Sundar Pichai added that the company is working to support some of its super-sized cloud customers during this period of high demand, "The incremental opportunities they bring extremely high short-term costs, but over the entire transaction lifecycle, as our own capacity goes online, the return on investment will be very significant." However, Ashkenazi also admitted that using external capacity will "temporarily put pressure on profit margins." Cloud computing: Revenue surges by 82%, backlog orders surpass $500 billion Despite the concerns over spending guidance, the company's already robust performance in the second quarter was overshadowed. The cloud business became the highlight of the financial report for the quarter. Alphabet Inc. Class C's cloud business achieved revenue of $24.8 billion, an 82% year-over-year increase, far exceeding analyst expectations of around $22.46 billion. Cloud operating profit reached $8.8 billion, more than doubling from the previous year, with an operating profit margin jumping from 20.7% to 35.6%. Pichai pointed out that the strong performance of the cloud business "is due to the strong demand for AI infrastructure and AI solutions." The core services of GCP, AI solutions, and AI infrastructure were significant growth engines. It is worth noting that this quarter, Alphabet confirmed the direct sales revenue from TPU systems delivery to customers' data centers, although the majority of this revenue will not be recognized until next year. More exciting for investors was the cloud backlog orders indicator, which represents future revenue. As of the end of the quarter, cloud backlog orders surged to $514 billion, increasing by over $50 billion from the previous quarter. The company expects over 50% of the backlog orders to be realized as revenue within the next 24 months. Ashkenazi stated that this growth is being driven by a wide demand for enterprise AI products. Pichai also revealed that Gemini Enterprise has been adopted by nearly 90% of the Fortune 100 companies; in the past year, nearly 500 cloud customers have processed over 1 trillion tokens each, with over 2,000 enterprises consuming over 100 billion tokens. In the security field, 90% of Fortune 100 companies are users of Alphabet Inc. Class C cloud security, with over 90% of Wiz customers enabling AI-driven security features, and AI workload protection increasing by over 45% month-on-month. Advertising and YouTube: Boosted by the World Cup, AI penetration deepens Alphabet Inc. Class C's services business contributed $95 billion in revenue for the quarter, a 15% year-over-year growth driven mainly by search. Search and other revenues surpassed $63 billion, with the retail and finance industries contributing the most. YouTube advertising revenue reached $11 billion, a 13% increase, benefiting from direct response and brand advertising, and significantly from the 2026 FIFA World Cup. Pichai noted that over 1.7 billion independent viewers globally watched World Cup-related content on YouTube, with over 550 million people watching through television, making it the most-watched World Cup in YouTube's history. On the advertising technology front, Chief Business Officer Philip Schindler stated that the company is fully integrating Gemini into its ad infrastructure, improving query understanding capabilities, especially in long-tail searches that were previously difficult to monetize. The relevance display for shopping ads increased by 20%. In addition, the AI Max tool has completed testing and is now adopted by 500,000 advertisers, coupled with AI-driven ad series like Performance Max, advertisers have seen an average of 15% increase in search conversions or value under similar ad spending returns. AI arms race: Model delays raise concerns, Gemini 4 holds high hopes Despite the strong momentum in its cloud business, Alphabet Inc. Class C's in-house development of large models faced headwinds. The flagship model Gemini 3.5 Pro, originally slated for release in June, continued to be delayed. In the AI programming and tools market, Alphabet Inc. Class C has clearly fallen behind in the continuous launch of enterprise-level upgrades by Anthropic and OpenAI, and the rise of Chinese open-source models has also increased competition pressure. Analysts repeatedly questioned the competitiveness of cutting-edge models during the analyst call. Pichai acknowledged, "In some areas, we are still at the forefront, but we recognize areas that need improvement, and programming and intelligent coding are examples." He then shifted the focus and revealed that the company has begun training the next generation of more powerful models, Gemini 4, dedicating considerable computing power and effort, and is "very confident in maintaining a leading position in the next generation of models." Additionally, the company plans to accelerate the model release schedule, potentially moving towards monthly updates. On the product front, the newly released Gemini 3.6 Flash and 3.5 Flash-Lite models were of interest. According to Pichai, over 9 million developers use Alphabet Inc. Class C models through APIs and product development each month, with the model's API processing approximately 220 billion tokens per minute, a significant increase from the previous quarter. Gemini app has reached 950 million monthly active users, higher than expected but slightly below the peak level of the previous quarter, with daily active users doubling year-on-year. Since its global expansion last year, AI Mode's monthly active userbase has surpassed 1 billion and has been seamlessly integrated with AI Overviews for a "seamless search experience." Other businesses and investment portfolio: Waymo unveils new vehicle, investment valuations surge The "Other Bets" division achieved revenue of $382 million for the quarter, below expectations. However, there were highlights in its projects: Waymo unveiled the latest vehicle model Oasis, featuring the sixth-generation Waymo Driver to the public; drone delivery service Wing completed over 1 million household deliveries and continued to expand partnerships with Walmart Inc. (WMT.US), DoorDash (DASH.US), and other partners; and AI drug research company Isomorphic Labs raised over $2 billion in funding to support its drug design engine and candidate pipeline. Additionally, Alphabet's investment portfolio saw a dramatic increase in valuation by nearly $100 billion for the quarter, driving the surge in net profit figures and showcasing the company's wide-ranging investments in the technology and innovation space. Despite the impressive performance in its cloud business, the cloud's backlog order growth, and the model delay concerns, Alphabet's stock price fell over 4% in after-hours trading. The stock had accumulated nearly an 11% increase year-to-date, but since the end of April, factors such as the delayed release of Gemini, the departure of several executives, and regulatory pressure have led to a cumulative pullback of around 9%. With Microsoft Corporation (MSFT.US) and Amazon.com, Inc. (AMZN.US) set to announce their financial reports next week, Alphabet, as the first major tech giant to report, has raised new questions about the sustainability of its "high investment for high growth but pressured earnings quality" model for the entire AI infrastructure investment frenzy. Montero from Investing.com stated that the growth in cloud backlog orders is at least a clear signal that "investments are translating into rapid, profitable revenue, as contracts will be immediately operational once capacity is in place," but the market's patience for cash consumption is being tested, "the market's expectation that the company can sustain itself solely on cash flow is being shaken." [Translated by Google Translate and human-proofread for accuracy]