Portfolio holding Alphabet (parent of Google) (GOOGL), which we initiated late last week, reported stronger-than-expected third quarter earnings Tuesday night.

Total revenues increased 39% year-over-year on a constant currency basis to $65.118 billion, topping estimates of $63.529 billion. Operating Income surged 87.5% YoY to $21.031 billion with margins expanding to 32% from 24% in the same quarter last year. This leads us to earnings per share, which grew 70.7% YoY to $27.99, beating estimates of $23.73. 

Google Services:

By reporting line, revenue from Google Services — which includes products and services such as ads, Android, Chrome, hardware, Google Maps, Google Play, Search, and YouTube— increased 40.6% YoY to $59.884 billion and slightly missed estimates of $60.373 billion. Let’s break down this number further to figure out the source of the miss.

Within Google Services is Google advertising, which is comprised of Google Search & other, YouTube ads, and Google Network. Google Search & other sales increased 40% to $37.929 billion and was driven by broad based strength across its business, led by retail. Meanwhile, YouTube ads revenue grew 43% to $7.205 billion thanks to strength in direct response and brand advertising. It’s also worth pointing out that YouTube recently surpassed 50 million music and premium subscribers, including those in trial.

The combination of Google Search & other with YouTube makes up Google Web site. Since Google Network revenues increased 40% to $7.999 billion and topped estimates of $7.516 billion, we believe part of the revenue miss may have come from the YouTube ad platform. 

But this should not have been a surprise to anyone. In what explains the miss, Ruth Porat said on the earnings call that YouTube was the one part of Alphabet’s digital advertising business that saw a modest impact from the Apple iOS14 changes. It’s not different from what we heard from Snap last week, which we wrote about in our initiation post of Google. However Alphabet’s results and management’s general tone about YouTube made us believe that the company is far more insulated from the privacy change relative to its digital advertising peers. 

Rounding out the Google Services segment, Google Other sales of $6.754 billion was better than expectations of $6.578 billion. From a profitability perspective, Google Services operating income grew 66% YoY to $23.973 billion, a huge beat compared to expectations of $21.044 billion with margins of 40% beating estimates of 34.86%.

Cloud Business:

At Google Cloud, revenues increased 44.8% YoY to $4.990 billion, missed estimates of $5.187 billion. On a more positive side, the segment reported a smaller than expected operating loss of $644 million versus the $899 million loss expected. Still, we would not spend a whole lot of time focusing on the operating loss here because management has prioritized revenue growth and market share gains.

During the conference call, CEO Sundar Pichai listed several reasons why he feels the Google Cloud has the “unique capabilities to meet the needs of enterprises, digital natives, and SMBs around the world.” One item of note we want to call out is how the BigQuery, the Google Cloud’s leading data warehouse solution, has reduced costs and increased productivity gains at Cardinal Health and ATB Financial. This is one example of how technology can be a deflationary force, which CEO Satya Nadella of Microsoft commented on during their conference call. We're starting to see how technology can be a deflationary force. 

Moonshot Bets:

This is the segment we talked about in the sense of "risky" investments by Google. This features Alphabet’s “moonshot” companies like Verily, Google Fiber, and the autonomous driving technology company Waymo. The segment reported an operating loss of $1.288 billion on revenues of $182 million. These results compare to a loss of $1.103 billion on $178 million of revenue in the same quarter last year. Of the divisions within this segment, we are most excited about Waymo, but we acknowledge that autonomous driving is still many years away, and the full value of their technology platform may be trapped for a while.  

Cash flows, Buyback:

Taking a look at some cash flow metrics, capital expenditures in the quarter was $6.819 billion, which was slightly lower than estimates of $7.11 billion. Alphabet generated a huge amount of free cash flow in the quarter, $18.720 billion compared to estimates of $15.219 billion. Management repurchased $12.6 billion worth of stock in the quarter, a figure that is consistent with the second quarter. 

The Bottom Line:

Overall, a fine quarter from Alphabet with a beat that simply may not have been big enough with the stock already up 60% year to date and trading nearly 5% away from its all-time high. After a run of this magnitude, it is only natural for the stock to take some time and digest its gains. But do not confuse the after-hours action for something that it is not. Alphabet still has a very bright future ahead with continued growth from YouTube, Google Cloud, and digital shopping experiences leading the way.