What's Hiding Inside Google and Microsoft's Earnings

Google fell hard after earnings, while Microsoft went higher.

That would make sense if one company had a great quarter and the other a terrible one…

Except that’s not what happened.

Both reported strong AI growth and good earnings.

Google Cloud grew more than 100%, Microsoft Azure nearly 50%.

While still producing tremendous amounts of operating income.

So why did the market treat them so differently?

Because the headline earnings are only 10% of figuring out what really happened.

Great investors ask:

Now more than ever, you must sharpen your skills in a world where one single assumption is being blindly rewarded.

The more you spend on AI infrastructure, the more profits you are assumed to bring in.

Anthropic’s S-1 filing is challenging that assumption like never before, especially as three huge red flags showed up in the business model and its numbers.

After digging through the 100+ page document and the company’s financials, I have reason to believe the valuation should be less than half of what the IPO suggests…

Click here to see my Anthropic deep dive.

Now Microsoft and Google give us another look at the other side of the AI trade.

The suppliers.

There are good news, and there are bad news sitting in plain sight.

But,

The bad news is what I think most investors are completely missing.

Because one sneaky accounting practice is hiding what really happened inside these companies.

A practice that explains how a company as big as Google can sell down 12% in a single day.

Let’s get into it,

What’s hiding inside Google and Microsoft’s earnings.

AI is now doing most of Google’s growth work.

This is exactly the type of shift you want to see in a business that has just invested heavily into a new market or technology:

And more importantly,

This new business now makes up 62% of the entire company’s revenue, already proving to be a great investment with quick monetization.

It’s now clear that AI is no longer a side business for Google.

But,

We must now begin to analyze whether most of its growth is already maturing, or whether there is significant market share available for grabs:

Contracted future AI commitments have grown 3x over the past twelve months, showing a future backlog of $520 billion against today’s $40.3 billion accumulated.

That means a more than 10x opportunity to keep growing revenues at Google, all within a service that is demonstrating available economies of scale and pricing power.

Otherwise, its operating margin would not be growing as fast as it is.

Based on that alone, I would be comfortable adding Google stock to my longer-term watchlist in a new AI world.

However,

That’s usually where most of the retail analysis stops, and where the professional work truly begins.

We’ll get to that in a minute, for now let’s go over what Microsoft did:

Like Google, Microsoft’s AI business is growing like a hiccup.

With 48% growth this quarter, and already making up 36% of overall revenues, there is one thing that makes Azure stand out over Google Cloud.

Operating margins.

The reason I care about this item is the reason everyone considering technology stocks today should care.

How these companies achieve AI revenue growth and market share matters a lot more than how big they have gotten so far.

Even though Google is growing faster and concentrating its business a lot more into AI, it is Microsoft that has done it the “cleanest.”

Let me explain,

Microsoft’s operating income is already larger than Google’s despite seeing slower AI growth and adoption.

And, operating margins are 14% better at Microsoft compared to Google.

Which essentially means both are achieving great things in adopting AI as a new business focus.

But,

If I had to pick based on sustainability and quality alone…

Microsoft wins, and the market just told you it agrees.

Here’s where the work begins.

Out of every dollar Google generated in operating income, 71% came through anything that is considered “other income.”

In other words,

$0.71 of every $1.00 earned did not actually show up as cash in the business, and that significantly deteriorates the underlying quality of earnings and the company itself.

The reason is that these non-cash items are made up of:

When you dig through the company filings, these positions are truly just one big bet into Anthropic.

Yes, Google has bet so much on Anthropic stock and bonds, that it nearly replaced everything else the company has achieved so far in its Cloud business.

It also means 71% of all earnings can be erased overnight if Anthropic fails to command the valuations it is targeting pre-IPO, or if its debt suddenly gets sold lower.

Right now, that is beginning to be the case as covered in my Anthropic S-1 analysis.

Bonds are now paying a 12% yield, making them junk status essentially.

And,

Posing a direct threat to Google’s earnings as a result.

Now look at Microsoft…

Only 8% of its operating income is made up of these non-cash items, creating another win in terms of quality above Google.

Revenue, operating income, and margins are much better because of this.

Google is only growing quicker because they are financing Anthropic’s ramp up to deliver more compute capacity, and in doing so risked their entire AI division.

In fact, this is already starting to happen:

When you strip out these “other income” items from Google, they actually aren’t doing that great.

These Anthropic investments spiked EPS to $9.11 last quarter, when the true operating business delivered only $2.90.

During the past quarter, when Anthropic made it clear that the AI economics were collapsing, these other items delivered a $0.52 loss per share.

Net earnings, then, were only $2.64 to fall ~9% below last quarter’s.

When a company as big as Google wipes out all of its free cash flow, and sees its earnings fall 9% due to irresponsible exposure…

The 12% selloff is just the type of justified reaction one can expect.

Now let me be clear about one thing…

Microsoft is not off the hook on these accounting red flags:

Microsoft is doing the same thing through its OpenAI stakes, and given the economics look the same as Anthropic’s, we can expect a similar result.

Still,

With only 8% of operating income coming from these non-cash items, the risk is significantly less compared to Google’s.

That doesn’t mean you can blindly pick Microsoft over Google because it is “less bad.”

The way I see it, both companies are choosing to hide things from me (an investor in them), and that just doesn’t go well with me.

Now comes the worst part…

The one every investor seems to ignore even with so many warning signs showing up in the financials for both Google and Microsoft.

The one that ultimately determines whether you buy this dip or wait for the dust to settle.

It’s the same thing happening with chips right now, and Intel being down 30% today is one of the cleanest expressions of that risk beginning to surface.

Click here to understand how the capital cycle affects future stock returns.

Now let’s get into that decision: