Microsoft’s AI Investments: A Bullish Outlook Amid Market Doubts
Despite robust Fiscal Q1 earnings reported in late October, Microsoft’s (MSFT) stock saw a 6% decline the following day. Investors remain cautious about Microsoft’s heavy investments in AI. However, I assert that this short-term skepticism overlooks the significant advancements that are beginning to reap rewards, supporting a bullish view on the stock.
This article explores Microsoft’s substantial AI investments, insight from its latest quarterly report, and why I contend that now is a favorable time to buy the stock.
What Concerns Are Affecting Microsoft Investors?
Recent doubts about Microsoft’s growth—especially concerning AI—stem from the significant capital investments the company has made without immediate improvements in profit margins for its cloud business. As of Fiscal 2024, Microsoft’s capital expenditures (CapEx) reached approximately $44.5 billion, an astounding increase of over 58% year-over-year.
During the Fiscal Q1 earnings report, the cloud segment’s gross margins dropped 2 percentage points, falling from 73% to 71%, despite a 22% rise in revenue compared to the previous year. This unusual combination of declining margins amid rising revenue has raised alarms, particularly as Microsoft has stated that it plans to increase CapEx in Fiscal 2025 beyond what was spent in Fiscal 2024.
The fundamental issue remains: If Microsoft cannot maintain rapid revenue growth to offset these large investments, margin pressures could linger, calling into question its historical profitability levels.
Strong Demand for AI Services
On a brighter note, Microsoft’s increased investments in AI have led to strong demand, which exhibits long-term sustainability. Instead of short bursts of usage, customers are entering into lengthy contracts, signaling reliable demand for AI services.
CEO Satya Nadella noted during the earnings call that Microsoft signed multi-year agreements—some spanning five to ten years—with several major customers for AI services. Such commitments suggest a solid foundation for future revenue growth.
Notably, commercial bookings for AI services climbed 30% year-over-year in Fiscal Q1. This momentum not only helps Microsoft retain customers but positions it well against competitors like Amazon’s (AMZN) AWS and Alphabet’s (GOOGL) Google Cloud.
Long-term contracts offer the advantage of predictable revenue streams, allowing Microsoft to expand its AI infrastructure confidently. The commitment from some of the world’s largest firms to embrace AI reinforces the notion that AI is more than a trend—it’s a transformative driver of future growth.
Significant Revenue Growth from AI
Another reason for optimism is Microsoft’s remarkable revenue growth resulting from its AI offerings, including the popular Microsoft 365 Copilot. The company is projected to surpass a $10 billion annual revenue run rate for AI as early as next quarter, marking this as the fastest-growing segment in Microsoft’s history.
This growth underscores that AI is not just another side project; it’s central to the company’s long-term profitability strategy. Microsoft anticipates a compound annual growth rate (CAGR) of 13.3% for its top line over the next five years, a strong indicator for potential investors.
Building a Competitive AI Infrastructure
Microsoft’s commitment to AI hardware innovation strengthens its long-term outlook. It has become the first cloud provider to implement Nvidia’s (NVDA) Blackwell system, which is an advanced AI server technology. This places Microsoft ahead of rivals like Amazon and Google.
The Blackwell system enhances performance for demanding AI tasks, such as large language models (LLMs), making Microsoft a preferred choice for organizations focused on building advanced AI applications. By debuting these state-of-the-art technologies, Microsoft is positioning itself to capture a larger share of the AI cloud market, potentially edging out AWS in the near future. This infrastructure investment is vital as AI adoption continues to grow across various industries.
Are Microsoft’s High Valuations Justifiable?
Microsoft’s position in AI boosts its attractiveness as a solid buy. However, questions arise about whether its stock valuation is disproportionately high compared to the broader market. While MSFT’s price-to-cash-flow ratio stands at 25.9x—outpacing Amazon’s 19.6x and Alphabet’s 21x—I argue that this premium reflects the company’s diverse revenue sources, superior margins, and impressive free cash flow generation.
In Fiscal 2024, despite a staggering 58% increase in CapEx, Microsoft finished with $74.07 billion in free cash flow, a 24.5% rise versus the previous year. This underscores that Microsoft’s cash generation remains strong despite heavy investments. Given the competitive advantages highlighted earlier, I anticipate these investments will yield favorable returns in coming quarters.
What Do Analysts Say About MSFT Stock?
According to TipRanks, MSFT holds a Strong Buy rating among analysts, with 26 Buy recommendations and three Hold recommendations among 29 analysts. The average price target is $495.33, implying a potential upside of 17.23%.
See more MSFT analyst ratings
Final Thoughts
Overall, the skepticism surrounding Microsoft’s AI investments and their impact on margins seems overstated. That’s why I view the stock as an attractive buy at this moment. While concerns about heavy short-term investment in AI are legitimate, the greater risk lies in not investing, especially with clear signs of strong demand. Allowing competitors to snatch up customers due to AI advancements would pose a far greater threat.
Disclosure
Disclaimer
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
