Despite Microsoft (MSFT) announcing strong first-quarter results in late October, the market reaction was lukewarm. This was evidenced by a 6% drop in the stock price the day after the earnings report, followed by a slight rise in the following days. This is primarily due to concerns about the scale of Microsoft’s investment in developing AI capabilities. As a long-term Microsoft bull, I think this lukewarm response focuses too much on short-term concerns and overlooks the great strides Microsoft has already made in AI, progress that is showing clear signs of paying off. I believe that Hence my bullish position on the stock.
In this article, I’ll take a closer look at Microsoft’s massive AI investment, drawing insights from the company’s latest quarterly report, and explain why I think this stock is a buy right now.
What’s bothering Microsoft investors lately?
Much of the recent skepticism about Microsoft’s growth story, particularly around AI, has centered on the fact that the company’s heavy investments have yet to translate into improved margins in its most profitable division, its cloud business. As of fiscal year 2024, Microsoft has accumulated approximately $44.5 billion in capital expenditures (CapEx), an increase of more than 58% year over year.
This concern was further heightened by Microsoft’s fiscal first quarter results. Despite a 22% year-over-year revenue increase, the cloud division’s gross margin declined by 2 percentage points from 73% to 71%. Typically, such revenue growth is accompanied by higher profit margins, but in this case, the company’s large investments temporarily compressed profitability. Additionally, Microsoft indicated that it expects to spend even more capital expenditures in fiscal year 2025 than it did in the recently ended fiscal year 2024.
The key issue is that unless Microsoft’s revenues continue to grow fast enough to offset these significant investments, margin pressures will persist and concerns about whether the company will be able to maintain historic levels of profitability. This means that there is a possibility that it will increase.
Strong customer demand and AI contracts
From a more optimistic perspective, there are some compelling reasons to view Microsoft’s increased AI spending as a positive sign for long-term growth. First and foremost, it’s clear that Microsoft is experiencing extraordinary demand for its AI services, and it’s neither short-lived nor speculative.
The company isn’t just looking at sporadic or short-term use of AI infrastructure. In fact, customers have long-term contracts. During a recent earnings call, Satya Nadella highlighted that some of Microsoft’s largest customers have multi-year contracts lasting five to 10 years for AI services. These long-term contracts demonstrate strong and sustained demand for AI technologies that are critical to Microsoft’s future revenue growth.
For example, commercial bookings for AI-related services increased 30% year-on-year in the first fiscal year. This forward-looking spending will help Microsoft win more business and prevent it from losing customers to competitors like Amazon’s (AMZN) AWS and Alphabet’s (GOOGL) Google Cloud.
Long-term contracts are particularly beneficial because they provide a predictable, recurring revenue stream. This allows Microsoft to continue to scale and invest in its AI infrastructure with confidence. Microsoft sees that its customers, including some of the world’s largest companies, are committed to using AI over the long term and believes that AI is not just a passing trend, but a fundamental driver of sustainable growth. reinforcing the idea that it is a transformative technology.
Increase revenue with AI
Another reason I’m bullish on Microsoft’s increased AI spending is the impressive revenue growth driven by the company’s AI-related products, including cloud services and tools like Microsoft 365 Copilot. The company is on track to surpass a $10 billion annual AI revenue run rate in the next quarter, making AI the fastest-growing business segment in Microsoft’s history.
The ability to generate such strong growth from a relatively new technology, especially at Microsoft’s scale, shows that AI is not just a strategic bet, but a core driver of the company’s future profitability. Microsoft is expected to grow its revenue at a compound annual growth rate (CAGR) of 13.3% over the next five years. This development should be a big plus for investors.
Strategic infrastructure expansion
Finally, to further support Microsoft’s bullish long-term outlook, it’s important to highlight the company’s leadership in AI hardware innovation. Microsoft became the first cloud provider to deploy Nvidia (NVDA) Blackwell systems, the most advanced AI server technology. This makes Microsoft one of the first companies to offer customers access to the latest and most powerful AI computing hardware, putting it ahead of competitors such as Amazon and Google.
The performance gains brought by Blackwell systems, particularly for AI workloads such as large-scale language models (LLMs), are significant and make Microsoft an increasingly popular choice for companies looking to build and deploy advanced AI applications. This makes it an attractive option. By being first to market with these advanced technologies, Microsoft has the potential to become a leader in the AI cloud space and could soon surpass AWS’s market share. As AI adoption accelerates across industries, expanding this infrastructure is critical to staying competitive.
Microsoft’s high valuation is likely justified
Significant advances in AI make Microsoft a strong buy. But aren’t the stock’s valuations relatively high compared to the rest of the market? In my opinion, they are, but for very good reasons.
For example, consider cash flow. This is especially important for large AI players with large capital investments. Microsoft’s price-to-cash flow ratio of 25.9 times is higher than Amazon’s 19.6 times and Alphabet’s 21 times. However, this premium may be justified by the company’s diverse revenue streams, best-in-class profit margins, and superior ability to generate free cash flow.
In fiscal year 2024, Microsoft ended the year with free cash flow of $74.07 billion, an increase of 24.5% year-over-year, despite a 58% year-over-year increase in capital expenditures. This highlights that Microsoft’s cash generation is not hurt by the investment. Given the competitive advantages mentioned above, I expect these investments to deliver even greater returns in the coming quarters, reinforcing the company’s strong financial position.
Is MSFT a buy, according to Wall Street analysts?
TipRanks rates the MSFT stock as a Strong Buy, based on 26 buy recommendations and 3 hold recommendations from 29 analysts. The average price target is $495.33, suggesting 17.23% upside potential.
See more MSFT analyst ratings
conclusion
I believe there is exaggerated skepticism about Microsoft’s AI investments and their potential impact on the company’s bottom line. That’s why I view this stock as an attractive buy at the moment.
While these concerns are valid, investing heavily in AI in a short period of time is risky for Microsoft and other technology companies, especially given the obvious circumstances. I think it would be much more concerning if there was no such thing. Signs of increasing demand. Enabling competitors to win customers through AI innovation poses greater risks.
disclosure
Disclaimer
