Source: PaxForex Premium Analytics Portal, Fundamental Insight
Last week, Microsoft experienced a 6.1% decline, marking its steepest drop since October 26, 2022, when it fell by 7.7%. Despite a 1% gain on Friday, the stock has risen less than 8% year to date (YTD), significantly underperforming the S&P 500's 20.1% YTD growth.
Here’s why Microsoft’s strong financial results didn't satisfy investors but why it still holds potential as a growth stock. Compared to the same quarter in the previous fiscal year, Microsoft achieved a 16% revenue increase, a 14% rise in operating income, and a 10% gain in diluted earnings per share (EPS). The company reports across three segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.
The Intelligent Cloud segment encompasses Azure and other cloud services, server products, and GitHub cloud. Additionally, Microsoft sometimes refers to the "Microsoft Cloud," which includes Intelligent Cloud plus cloud services like Microsoft 365, part of the Productivity and Business Processes segment.
In the latest quarter, Microsoft Cloud revenue reached $38.9 billion, growing by 22% with a 71% gross margin. This high-margin cloud segment now constitutes 59% of Microsoft’s total revenue. Remarkably, Microsoft Cloud alone generated more revenue this quarter than the entire company did during the same period four years ago.
Microsoft’s rapid growth in cloud products and services has been a significant driver of its recent financial performance. Acquisitions, such as Activision Blizzard, also contributed, boosting Xbox content and services revenue by 61%. Excluding this acquisition, Xbox revenue would have grown by only 8%. However, not every segment performed strongly; Windows products and devices, for example, saw only a 2% increase.
While Microsoft’s overall results were solid, investor concerns arose from its guidance and substantial spending on artificial intelligence (AI). For the quarter, Intelligent Cloud revenue grew by 20%, and Azure, Microsoft’s fastest-growing cloud service, increased by 33%. However, next-quarter guidance projects Intelligent Cloud revenue to grow by 18% to 20% in constant currency, and Azure to grow by 31% to 32% - signaling a slight deceleration.
Though a marginal slowdown in growth might not normally alarm investors, Microsoft’s heavy investments in AI have raised expectations. At present, these investments have not substantially impacted short-term growth figures. During the earnings call, Microsoft highlighted its progress, mentioning the introduction of Nvidia’s Blackwell system with GB200-powered AI servers - the latest in cutting-edge AI technology.
As Microsoft increases AI spending, investors are eager to see this investment translate into tangible results. Capital expenditures (capex), including finance leases, totaled $20 billion for the quarter, meaning nearly 30% of each revenue dollar is reinvested in capex.
Chief Financial Officer Amy Hood stated that around half of the cloud and AI-related spending is allocated to long-term assets expected to support monetization for the next 15 years or more, while the remaining investment is directed toward servers to meet customer demand.
This message suggests that some of Microsoft’s capex may take time to yield results, positioning the company for future growth. Microsoft also indicated that capital expenditures may continue to increase in response to demand signals, a strategy that could add pressure from short-term-focused investors.
While some may criticize Microsoft’s substantial spending on AI, the company has ample resources to support such investments. Its strong balance sheet includes more cash and liquid assets than debt, and its robust capital return program includes dividends and stock repurchases. In fiscal 2024, Microsoft reduced debt by $29.07 billion, paid $21.77 billion in dividends, and repurchased $17.25 billion in stock.
Concerns would arise if this capex surge compromised Microsoft’s capital return program or financial health. However, the company is well-positioned to invest in AI aggressively without impacting its financial stability, solidifying its standing as a leader in enterprise AI and cloud infrastructure.
Microsoft’s capital could also support mergers and acquisitions (M&A) as an alternative to organic growth. However, given that many AI investments are upgrades to existing products, the company seems focused on innovation from within. Heavy reliance on M&A could indicate weak organic growth - a potential red flag for tech companies, as it could reflect poor management, a lack of talent, or competitive disadvantages.
The recent drop in Microsoft’s stock may present a buying opportunity for those who align with its capital allocation strategy. For investors wary of high AI spending, a wait-and-see approach might be more suitable. With a price-to-earnings ratio of 33.9, Microsoft offers diversified exposure to AI, cloud, hardware, and gaming at a reasonable price. Despite its elevated spending, Microsoft continues to post double-digit growth in revenue and EPS, making it a compelling blue-chip growth stock.
As long as the price is above 405.00, follow the recommendations below:
- Time frame: D1
- Recommendation: long position
- Entry point: 411.20
- Take Profit 1: 425.00
- Take Profit 2: 435.00
Alternative scenario:
If the level of 405.00 is broken-down, follow the recommendations below:
- Time frame: D1
- Recommendation: short position
- Entry point: 405.00
- Take Profit 1: 400.00
- Take Profit 2: 390.00
