Before Alphabet reports Q3, a closer look at Q2: of the more than $9 in earnings per share, over $6 came from gains on equity investments. The money is real, but customers did not pay it.
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0:00In the second quarter of this year, April through June, Google's parent Alphabet earned a little over $9 per share, which looks impressive. But the company disclosed that gains on its equity investments contributed over $6 of that: shares it holds in other companies rose in value, and that part is not money paid by customers.
0:22Third-quarter results come out before the earnings call, which is at four-thirty in the morning, Beijing time, on October 29. Before they arrive, let's take the second quarter apart.
0:37One note first: take that investment gain out of earnings per share, and what's left still can't be read as core-business earnings; it also mixes in other income, expenses and taxes. The core business itself did get stronger: revenue grew more than 20% year over year, and operating profit about 30%; that includes an acquired company being consolidated and sales of in-house chip systems, so not all of it is organic growth.
1:07Cash is a different story. In the second quarter, the company's own free cash flow figure was negative, nearly $6 billion: more went into data centers and chips than operations brought in. Part of that negative figure is because more than $10 billion was tied up in receivables, inventory and similar working capital; management says part of the inventory is being built up to deliver its in-house AI chips; that is only an explanation; whether the cash comes back quickly hasn't been shown.
1:40And it's one quarter: over the past four quarters combined, free cash flow is still positive at more than $50 billion, though it has been getting worse lately.
1:50In July, the company also raised its full-year capital spending guidance; by that guidance, it will spend more in the second half than in the first; management also said capital spending will rise significantly again next year. Capital spending is the money for building data centers and buying chips.
2:08Shareholders have another tally to check. There were no buybacks in the first half, and total common shares at period end were up about 1.2% from the start of the year; where the new shares came from, the research hasn't fully pinned down. The company has also issued preferred stock that must convert into common shares. And stock compensation is a cost too; it just isn't deducted in free cash flow.
2:35Of course, these numbers have another side: second-quarter operating cash was up about 40% from a year earlier, and the cloud segment's operating margin reached about 35%, though that measure leaves out shared AI research at the group level. Spending on inventory and capacity first and collecting cash later may also be reasonable; and that six-dollar-plus investment gain isn't fake money; it just isn't money customers paid, it can be bigger or smaller each quarter, and it could even turn into a loss.
3:11So when these results come out, one reminder first: if third-quarter earnings per share swing sharply, check how much the investment gains changed before looking at the core business. Then I'll be watching three things. First, whether capital spending is still growing faster than operating cash, and whether any improvement in cash comes from customers paying, not from paying bills later or holding less inventory. Management already expected in July that free cash flow would stay under pressure, so another quarter of negative free cash flow is not necessarily new bad news.
3:50Second, the cloud business: how much of cloud revenue is ongoing cloud services versus chip-system deliveries; management has already flagged cost pressure from outside computing power and depreciation, so if cloud margins dip, that isn't necessarily an unexpected deterioration. Third, whether the share count is still rising. One quarter can't tell the whole story; it takes several quarters in a row.
4:17Google's business really is getting stronger, but it hasn't yet shown that this growth turns into real, lasting cash for every share. This is not investment advice, and the author may hold the stocks mentioned. See you next time.
Ahead of Tesla's Q3 earnings, a closer look at Q2: revenue rose by a quarter year over year, while operating profit fell by more than half. More vehicle sales did not translate into higher earnings.
