Microsoft’s Strategic AI Investments and Robust Earnings Silence Bears, Propelling Future Growth

Microsoft recently distinguished itself by maintaining a stable capital expenditures outlook, a decision that handsomely rewarded its stock in Wednesday evening's after-hours trading. This encouraging news on capex coincided with better-than-expected fiscal 2026 fourth-quarter results, primarily fueled by the strong performance of its Azure cloud unit, alongside confident current quarterly guidance.

In the three months ending in June, revenue surged by 18% year-over-year to an impressive $90 billion, comfortably exceeding LSEG's consensus estimate of $87.6 billion. Adjusted earnings per share (EPS) climbed 30% from the previous year, reaching $4.74. While a direct comparison to LSEG's $4.24 consensus wasn't explicitly stated, Azure's cloud revenue growth, measured on a constant currency basis, soared to 43%, surpassing FactSet's consensus of 40.26%. On a reported basis, Azure cloud revenue also grew by 43%, once again ahead of FactSet's 40.4% consensus.

Is this the turning point for the Microsoft narrative? Over the past 12 months, shares had seen a roughly 24% decline amidst concerns that the company was lagging in the competitive AI race. Critics had voiced apprehension about Microsoft's extensive reliance on seat-based subscription software, deeming it vulnerable to AI disruption. There were also sentiments that the company's AI tools lacked innovation and that it depended too heavily on OpenAI for cloud expansion. While it's crucial not to overreact to initial post-earnings stock movements, Microsoft's 9% after-hours rally strongly suggests that investors are either changing their perspective or acknowledging their prior excessive pessimism.

Azure revenue growth accelerated impressively to 43%, significantly exceeding management's previous quarter forecast of 39% to 40%. Earlier Microsoft quarters faced headwinds from capacity constraints, leading to missed Azure revenue opportunities. Bringing new capacity online more rapidly than anticipated proved to be a pivotal factor behind this quarter's positive surprise. Microsoft successfully deployed 31 new data centers across five continents during the quarter, bringing its year-to-date total to 88. Management further highlighted that the $51 billion sequential increase in its commercial remaining performance obligation (RPO) was driven by customer commitments beyond frontier AI model developers. This detail is particularly significant as investors have grown increasingly wary of hyperscalers becoming overly reliant on a select few customers, such as OpenAI and Anthropic, for their massive AI infrastructure investments. A broader, more diversified customer base should effectively alleviate these concerns. RPO, notably, serves as a crucial metric for signed contracts yet to be executed.

Another factor countering the bearish outlook was the performance of M365 Copilot. To be transparent, the authors express some reservations, suggesting it trails some other AI tools available. However, Microsoft continues to attract new customers, and user satisfaction scores are on an upward trend. The company reported that Copilot now boasts over 30 million paid seats, a notable improvement from the 20 million reported three months ago and 15 million six months prior. During the earnings call, CEO Satya Nadella hinted at the upcoming launch of a Copilot "super app" later this quarter.

Are hyperscalers spending excessively without adequate returns? Microsoft invested $41 billion in the quarter, including assets acquired under finance leases, marking a 70% increase year-over-year and aligning with analyst models. However, a key distinction setting Microsoft apart from other hyperscalers this earnings season is its decision to keep its calendar year 2026 capital expenditure investment expectations unchanged. Although an accounting shift from finance to operating leases technically adjusts its expectations lower to $175 billion from $190 billion, capital expenditures remain substantially higher than a year ago and are projected to rise further in fiscal 2027. Crucially, the company appears committed to its spending discipline, choosing not to raise its outlook every quarter even amid strong demand.

While the precise investment figures for Microsoft's new fiscal year remain undisclosed, the market clearly appreciated its fiscal prudence on Wednesday evening. Adding to the positive sentiment, CFO Amy Hood provided an excellent Azure revenue growth forecast. The business is anticipated to accelerate once more, with revenue growth guided to 45% in constant currency for the first quarter of fiscal year 2027, surpassing the Street's expectation of approximately 42%.

Microsoft's ability to invest within its means is also commendable. In stark contrast to Alphabet, which reported negative free cash flow in the second quarter, and Meta Platforms, which generated only $1.7 billion in free cash flow, Microsoft demonstrated robust cash generation, producing $19 billion in free cash flow during the quarter. This financial discipline empowers the company to continue aggressive AI investments while simultaneously returning capital to shareholders, including $3.4 billion in share repurchases during the quarter. (Amazon, the fourth major hyperscaler, is scheduled to report earnings after Thursday's close.)

The overall results were both encouraging and sufficiently strong to maintain interest in this fiercely contested stock. Microsoft's strategy of offering cloud customers a diverse selection of AI models based on quality, latency, cost, and compliance appears to be resonating well. Nonetheless, the company is not entirely out of the woods. Some lingering reservations persist regarding Copilot adoption and paid seat growth, and the market eagerly awaits more details on the upcoming "super app" later this year. The authors reiterate a 2 rating and a $500-per-share price target.

Guidance Highlights:

• Beyond the strong Azure growth forecast, management expects total revenue for fiscal Q1 to range between $89.85 billion and $90.95 billion, indicating growth of 16% to 17%. The midpoint guidance of $90.4 billion surpasses FactSet's consensus of $89.7 billion.
• Operating expenses are projected to be between $16.8 billion and $16.9 billion, implying 7% to 8% year-over-year growth, which is below FactSet's consensus of $17.28 billion (lower being favorable).
• Capital expenditures are anticipated to exceed $50 billion for the quarter.

Why Microsoft is a Core Holding:

Microsoft stands as a fundamental pillar of global productivity, largely due to its foundational cloud platform, Azure, and its ubiquitous Office 365 suite. The company remains a critical frontrunner in the evolving artificial intelligence landscape.

Key Competitors: Amazon, Alphabet, and Salesforce.

Investment Details: Most recent buy: August 5, 2024. Initiated: December 4, 2017.

Segment Outlook for Fiscal Q1 Revenue:

• Productivity and Business Processes (Office, LinkedIn): Expected to be between $36.7 billion and $37 billion, surpassing FactSet's consensus of $36.6 billion.
• Intelligent Cloud (Azure, servers): Projected at $40.95 billion to $41.25 billion, exceeding FactSet's consensus of $40.1 billion.
• More Personal Computing (Windows, gaming): Forecasted between $12.2 billion and $12.7 billion, falling below FactSet's consensus of $12.9 billion.