The question on investors’ lips following Microsoft’s (MSFT) earnings call last week is: are substantial capital investments in AI infrastructure justified when growth and margins don’t reflect improvements?
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Although I’m a long-term bull and reiterate my optimistic stance following the tech giant’s results, the stock has been in limbo over the past six months. Some impatient investors have abandoned ship, struggling to acquiesce to the narrative that Microsoft’s market performance and investment cases are compelling.
Overall, I view MSFT’s earnings results from last week with optimism, given the company is backed by strong commercial bookings and sustained demand for AI services. Given the robust revenue growth and margins, I believe these ongoing investments are enough to support a long-term bullish outlook on Microsoft, which boasts some of the best-in-class business fundamentals of any sector.
Another Strong Quarter for Microsoft
Overall, my bullishness on Microsoft remains firm after another solid quarter was reported, which marked the tenth consecutive earnings beat. Microsoft delivered EPS of $3.23 when Wall Street was expecting $3.11.
Additionally, Microsoft reported revenues of $69.9 billion, up 12% year-over-year and $823 million above the consensus estimate. Based on its three segments, the one that grew the most was the Intelligent Cloud business, which jumped 19%. In the consolidated results, gross margins reached 69%—arguably one of the best gross margins among any businesses in the world—while Microsoft’s operating profit margin jumped to 45% with a total operating income of $31.7 billion. Again, very few businesses can boast such sturdy results.
On the operational side, Microsoft reported commercial booking revenues grew year-over-year by 67% in FYQ2. Even with seemingly rock-solid numbers, it wasn’t enough to please the markets, as MSFT stock shed ~6% post-earnings.
What Matters Most for MSFT
Arguably, a great chunk of Microsoft’s 31.5x forward earnings multiple is directly related to its progress with AI implementation, particularly in its most profitable segment today—the cloud business. The Intelligent Cloud segment has been one of the main drivers of the almost 75% share price appreciation over the last two years.
However, the big reason for skepticism after Microsoft’s results was precisely two key issues regarding the cloud business. The first was that revenue growth from Azure and other cloud services fell from 33% in FYQ1 to 31% in FYQ2. The second point was that the guidance for FYQ3 was for growth between 31% and 32%, still below what MSFT recorded two quarters ago.
According to Microsoft’s management team, the explanation for this has nothing to do with weakening demand for AI services but rather two factors: (1) challenges in non-AI components, where companies are trying to balance the migration of their work with adopting AI workloads. There is a challenge in adjusting investments, and this process often takes time and impacts results; and (2) the capacity limit affecting the performance of the segment, which still needs more infrastructure to sustain growth—even though the long-term infrastructure investments made in recent years are still not enough.
The other topic of concern was Microsoft Cloud margins. The outlook for FYQ3 implies margins of 69%, which would be the lowest margins since FYQ2 2024. It’s worth noting that in FYQ1, the cloud division’s gross margins had already fallen quarter-over-quarter from 73% to 71%, and now, in FYQ2, margins were at 70%.
Management argues that the margin drop correlates with the impact of scaling the AI infrastructure. However, the reality is that investors were disappointed to see $22.6 billion in capital expenditure supporting AI initiatives in the three months when margins and growth rates have been impacted. Even though the funding comes from free cash flow (which also fell 29% year-over-year thanks to these AI spendings) and not from extra debt.
Rising RPOs and Bookings Back Ongoing AI Investment
Contributing to my bullish thesis on Microsoft, although the cloud results show an inevitable slowdown, I’m still very encouraged by the overall context. The company has been spending on developing its business clearly because it is seeing a customer response. This is quite evident when we look at the remaining commercial performance obligations (RPO), which are currently soaring, partly due to AI.
Microsoft’s RPOs are currently at $298 billion, an increase of $39 billion from FYQ1 and about $76 million higher compared to last year, showing very robust rates of increase. So, we see tangible results in RPOs which supports the case for continued investment in AI infrastructure.
Is Microsoft a Buy, Hold, or Sell?
Although Microsoft’s earnings report displeased the market, the bullish consensus prevails.
On TipRanks, the stock carries a Strong Buy consensus rating based on 28 Buy, three Hold, and zero Sell ratings over the past three months. Notably, not a single analyst rates MSFT as a Sell despite last week’s earnings call stumble. Currently, MSFT’s average price target of $508.68 per share implies a 22.5% upside potential from current levels.
It’s worth noting that although there were no downgrades, there were four price target trims, the most significant of which came from Wolfe Research analyst Alex Zukin, who downgraded his price target from the previous $515 to $475. According to the analyst, he points out that Microsoft shares “are likely range bound until such time as either execution or capacity improves.”
MSFT Continues to Offer Superb Exposure to the Tech Market
Microsoft’s quarterly results showed that the company struggled to sustain its high revenue growth rates and margins, particularly in the cloud. However, most of these challenges were unrelated to demand, which, in my view, is key to supporting the case for continued infrastructure investments. This demand is clearly demonstrated by the solid growth in RPOs.
As a result, short-term market skepticism seems misplaced, and a long-term buy-and-hold strategy appears to be the more reasonable approach for Microsoft stock. Moreover, MSFT is still trading at a 7% discount in early trade this week, making this tech giant a strong buy-the-dip contender in early 2025.
