Why Alphabet shares crashed: How Google AI Mode is eating into search ad revenue

It is irony at its finest. Google has spent the last few years going on and on about how search will  be completely revolutionised and upgraded with the use of AI and to their credit, it has become a lot better. They just hit a five-year high in query growth and then that led to Alphabet seeing the biggest plunge in their valuation they ever have with a drop of over $500 billion. Why did this happen despite the query growth? Because query growth did not translate into revenue. Infact their revenue growth rate flipped considerably from last quarter. All because of Google’s AI mode which people use a lot and it pays them less per query. 

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The numbers that spooked Wall Street

Advertising, including search advertising, surged 12% to around $63.3 billion, cooling off considerably from 17% growth seen in the second quarter. The number started at 19% for the year. A lot of ground has been lost in just two quarters. Please check your brakes. Overall revenue of $127.6 billion came up short of analyst expectations of $128.2 billion, with advertising revenue missing by $1.4 billion.

Cloud performed its very best. Cloud revenue nearly doubled to $30.7 billion. This was the company’s version of acing the test and being grounded for the car trouble.

A hit that pays badly

This is where it gets a little silly. Google’s Chief business officer Philipp Schindler put the blame for the slowdown on AI Mode, which earns less per query than classic search. Google has not revealed how much less but less. AI Mode queries also run about three times longer than the usual kind, which you would assume means more room for ads. Not quite.

Google’s fix is more ads in AI Mode, and the rollout will happen worldwide. This is a bold move. People use AI mode because it gives you the answer without having to scour multiple links and partly because it does not look like a billboard that happens to answer your query. Nothing says helpful assistant like a sponsored result.

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Why a better answer means fewer ad dollars

Classic search is a listing of links, and advertisements are sandwiched in between, and the advertiser pays every time you click. With an AI solution to your problem, it becomes less necessary for you to click anywhere, thus reducing the incentive for the advertiser. The details have not been revealed by Google yet, but the concept is simple enough to understand. In a system that is designed to provide you with an answer, it becomes impossible to direct you somewhere else, which is precisely how the search ads make money.

The bill for being clever

This is followed by the price of all of this brilliance. Capital spending climbed to $51.4 billion and free cash flow turned negative at $9.1 billion. Microsoft announced later that night and its stock price went up more than 5% aided by free cash flow that was positive. Same AI boom, but entirely different mindset.

Spending at that scale works when search keeps making the money to cover it. Search is still printing the dollars for Google. It is just on a slower press.

What Google says will happen next

Bank of America analysts claimed the shifting ad budgets is going to be part of the worry. However, Google’s own numbers show users are not leaving. People are googling plenty. They are just getting results that Google earns less on.

Google CEO Sundar Pichai talks about a future where the AI Overviews and AI Mode merge with Search in an experience with longer queries. The investors have been hearing the story, and now they need to see it demonstrated. It is funny that Google monopolised search to the extent that the only company that can disrupt it turned out to be Google. 

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