Google's Q2 Cloud Business Once Again Exceeds Expectations, But Negative Free Cash Flow Triggers Valuation Reassessment

Original author: Soso Value

Alphabet released its 2026 Q2 earnings: Revenue, cloud computing, and advertising business overall beat expectations, with Google Cloud's growth once again surpassing the most optimistic buyer forecasts; the company simultaneously raised its full-year capital expenditure guidance and expects to continue significantly increasing investment in 2027, supporting the AI chip, server, storage, and data center industry chain.

However, rapid growth in capital expenditure pushed free cash flow negative, and EPS excluding investment gains was also below expectations. Management acknowledged that Gemini still needs improvement in coding capabilities but did not provide a clear timeline to catch up or verifiable quantitative targets. Cloud business backlog orders continued to grow, but the sequential growth rate slowed significantly. Alphabet's stock price fell about 3% in after-hours trading.

Q2 Results: Revenue Beats, Core EPS Slightly Misses

Q2 revenue was $119.8 billion, up 24% year-over-year, exceeding the consensus estimate of $116.96 billion.

Net profit surged 297.6% year-over-year to $112.1 billion, with EPS of $9.11. This includes $77.1 billion in unrealized net gains from the increase in equity investment valuations; excluding other income, EPS was approximately $2.85, below the consensus estimate of $2.95.

Therefore, the substantial growth in net profit and GAAP EPS was primarily driven by investment gains. The core business performance is better judged through operating profit, cloud business growth, and cash flow.

Cloud Business Exceeds Most Optimistic Forecasts, Backlog Growth Slows

Google Cloud revenue was $24.77 billion, up 81.8% year-over-year, accelerating further from Q1's 63.4% and significantly exceeding the consensus estimate of 64.3% and the bullish buyer forecast of 75%.

Cloud backlog orders grew 11.7% sequentially to $514 billion, an increase of about $54 billion in the quarter, driven mainly by enterprise AI product demand and TPU orders. It is expected that over half of this will be recognized as revenue in the next 24 months. However, the incremental backlog has slowed noticeably compared to earlier periods. Whether Cloud can maintain its current growth rate will depend on the scale of new contracts, computing power delivery speed, and the pace of TPU revenue recognition.

Gemini Enterprise has become a significant growth driver for Cloud, with nearly 90% of Fortune 100 companies using it. Customer model calls via the API have risen to over 22 billion tokens per minute, a 37.5% increase from 16 billion in the previous quarter, indicating that enterprise AI demand is still expanding rapidly.

Advertising business broadly met expectations:

· Total advertising revenue was $81.63 billion, up 14.4% year-over-year, slightly above the market expectation of $81.1 billion.

· Search revenue was $63.27 billion, up 16.8% year-over-year, roughly in line with the market estimate of $63.3 billion, but the growth rate was lower than Q1's 19.1%.

· YouTube advertising revenue was $11.06 billion, up 12.9% year-over-year, exceeding the estimate of $10.8 billion.

· Google Network revenue was $7.3 billion, down 0.7% year-over-year, still slightly above the estimate of $7.13 billion.

Capex Raised Again, Free Cash Flow Turns Negative

Q2 capital expenditure reached $44.92 billion, up 100.5% year-over-year and 25.9% quarter-over-quarter. The company raised its 2026 capital expenditure guidance from $180 billion - $190 billion to $195 billion - $205 billion, an increase of $15 billion in both the lower and upper ends, and expects capital expenditure to grow significantly again in 2027.

The continuously increasing investment reflects that computing power supply constraints still limit Google Cloud, Gemini training, and TPU demand, providing medium to long-term support for demand in AI accelerators, storage, servers, optical communications, and data center construction.

The corresponding cost is already reflected in cash flow. Q2 free cash flow dropped from $10.12 billion in the previous quarter to negative $5.86 billion, with capital expenditure exceeding operating cash flow for the first time. As depreciation, energy, and data center operating costs gradually flow into the income statement, market valuation of Alphabet will increasingly depend on the revenue conversion rate and return on capital of its AI investments.

Earnings Call: Computing Power Constraint Continues, Gemini 4 Still Needs to Prove Competitiveness

Management stated that the company still severely lacks computing power. In Q3, it will temporarily expand third-party compute leasing to prevent short-term capacity shortages from causing large customer churn. Third-party computing power is costly and is expected to put some pressure on Cloud margins, but it helps preserve long-term contract value.

Google delivered TPU systems to customers and recognized revenue for the first time this quarter. Only a small amount of revenue will be recognized in 2026, with the majority of existing TPU contract revenue to be recognized in 2027. Expanding TPU sales from internal infrastructure to external systems increases Google Cloud's addressable market and improves the visibility of demand for upstream advanced processes, HBM, servers, and networking equipment.

On the model front, Google has initiated the largest-scale pre-training of Gemini 4, hoping to regain a leading position with the next frontier model. Management simultaneously acknowledged that the current model's coding and agent programming capabilities still need improvement. As Gemini 4 has not yet announced a clear launch date, performance data, or commercialization path, the earnings call failed to fully alleviate market concerns about Google's model competitiveness.

This earnings report proves that enterprise AI demand remains strong and Google Cloud is accelerating the monetization of its AI investments. The after-hours decline reflects that the market's evaluation criteria have further increased: beating cloud revenue expectations remains positive, but negative free cash flow, continuously expanding capital expenditure, and the uncertainty surrounding Gemini's frontier capabilities will together determine Alphabet's valuation range in the next phase.