To The Moon

Takeaways

• Q1 revenue rose 22%, while operating income grew 30%.

• Cloud revenue grew 63% and margin reached 32.9%.

• Search revenue rose 19%, with a lower traffic acquisition cost ratio.

• Q1 capex consumed 78% of operating cash flow.

• Forward P/E is about 24.6 times, while free cash flow yield is only 1.5%.

$Alphabet(GOOG)$ reports second quarter results after the close on July 22. Wall Street expects revenue of roughly $116.9 billion, up 21.3% year over year, with EPS of $2.90.

That EPS will look much lower than the $5.11 reported in Q1. The comparison is misleading. Equity investment gains added $28.7 billion to Q1 net income and $2.35 to EPS. I would strip those gains out and concentrate on operating income, free cash flow and the growth rate of each major business.

Q1 revenue reached $109.9 billion, up 22%, or 19% in constant currency. Operating income rose 30% to $39.7 billion, while operating margin increased from 33.9% to 36.1%. Core profit grew faster than revenue, so the heavy AI investment has yet to damage Alphabet's consolidated operating efficiency.

Search and other revenue increased 19% to $60.4 billion. Google Cloud grew 63% to $20.0 billion. Subscriptions, platforms and devices rose 19% to $12.4 billion, while YouTube ad revenue increased 11% to $9.9 billion. Google Network revenue declined about 4%, though it now represents a fairly small part of the group.

Revenue growth by business

Search is holding up better than many investors expected. Google Services operating margin rose from 42.3% to 45.3% in Q1. Traffic acquisition costs were $15.2 billion, equal to 19.7% of advertising revenue. That ratio was about 20.6% a year earlier.

AI queries require more computing power, but Google is offsetting the cost through better ad targeting, higher query volume and lower inference costs. The company says the cost of its core AI responses has fallen by more than 30% since Gemini 3 launched.

This is one of the most useful Q2 indicators. Search revenue can still grow while AI usage increases, but margins will show whether the economics are improving. A few quarters of higher engagement with falling Services margins would be a warning sign.

Cloud provides clearer evidence that the investment is producing revenue. Q1 Cloud revenue increased from $12.3 billion to $20.0 billion. Operating income rose from $2.2 billion to $6.6 billion, lifting operating margin from 17.8% to 32.9%.

That is a large improvement. Revenue grew 63%, while operating income roughly tripled. The combination suggests that custom TPUs, software optimization and higher utilization are lowering the cost of serving each customer.

Google Cloud operating performance

Cloud backlog reached $462 billion and nearly doubled from the previous quarter. Roughly half is expected to convert into revenue within 24 months. That provides good visibility, though revenue recognition will depend on how quickly Alphabet can install and deliver new capacity.

Google is still turning away some Cloud business because it lacks enough compute. This makes delivery a major Q2 topic. I will be watching Cloud revenue growth, backlog conversion and operating margin. Strong demand matters less if data centers are delayed or new capacity comes online at a much higher cost.

The cash flow figures show why investors remain nervous. Q1 operating cash flow was $45.8 billion. Capital expenditure reached $35.7 billion, consuming 78% of operating cash flow and leaving $10.1 billion of free cash flow. Free cash flow had been around $24.5 billion in each of the previous two quarters.

Cash flow and capex

Alphabet expects 2026 capex of $180 billion to $190 billion, roughly double the 2025 level. Management also expects another significant increase in 2027.

The spending plan is already backed by large contractual obligations. Alphabet had $332.4 billion of purchase commitments and other obligations at the end of Q1, including $138 billion due within 12 months. Most of that relates to technical infrastructure, equipment, inventory and energy contracts. These commitments support faster capacity delivery, but they also reduce the company's ability to cut spending quickly if demand slows.

The balance sheet can handle the investment. Alphabet ended Q1 with $126.8 billion in cash and marketable securities and $77.5 billion of long term debt. It raised $31.1 billion from debt during the quarter and issued another $20 billion after quarter end, bringing pro forma debt above $100 billion.

Alphabet also announced an equity raise expected to total about $85 billion, including a $10 billion investment from Berkshire Hathaway. The financing equals roughly 2% of Alphabet's current $4.26 trillion market value. The immediate dilution is manageable, though investors should track the share count, preferred dividends and reduced room for buybacks.

The 100 year bond is part of the same funding strategy. Alphabet sold £1 billion of notes carrying a 6.125% coupon and maturing in 2126. The bond was issued at 99.732 and traded near 91.6 in mid July, a decline of about 8%.

Annual interest on the century bond is only £61.25 million, which is immaterial next to Alphabet's operating profit. The price decline mostly reflects its extreme duration, changes in UK interest rates and the increase in technology debt supply. For shareholders, total leverage and dilution matter more than the trading price of one bond.

Custom chips are supposed to improve the return on all this spending. TPU 8t is aimed at model training, while TPU 8i focuses on inference. Google says it reduced Gemini serving costs by 78% during 2025.

The recently reported Frozen v2 chip goes further by tailoring the hardware directly to Gemini. Engineers believe it could process six to ten times more tokens per unit of power than Google's latest custom AI chips. Deployment could begin in 2028, although the project is still in development.

Frozen v2 will not affect near term revenue. Its first financial impact would appear in Cloud capacity and the cost of running Gemini across Search and other Google products. Better efficiency would let Google serve more customers with the same power and data center footprint. The tradeoff is flexibility, since chips designed around a specific model architecture can become less useful when models change.

Valuation leaves less room for a weak quarter. Alphabet trades at about 24.6 times forward earnings and 10.6 times sales. At a share price near $352, the market is implying forward EPS of roughly $14.30.

Using that EPS, a 22 times multiple gives a value near $315. A 25 times multiple produces about $358, while 28 times gives roughly $401. The current price sits close to the middle case.

Free cash flow gives a more demanding result. Alphabet generated $64.4 billion of free cash flow over the past 12 months, equal to a yield of about 1.5% on its current market value. That works out to roughly 66 times trailing free cash flow.

The P/E ratio is flattered by investment gains, while the free cash flow multiple is depressed by unusually high capex. Taken together, the valuation assumes that Cloud growth stays high, Search margins remain stable and today's infrastructure spending produces much more cash over the next several years.

I remain cautiously positive going into the report. Q1 operating performance was strong and Cloud is producing real profit. The hurdle is higher now. Alphabet needs to convert its backlog, keep Search margins healthy and prevent free cash flow from staying near the Q1 level.

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