Despite Microsoft (MSFT) reporting strong Fiscal Q1 earnings in late October, the market’s reaction was sluggish. This was evidenced by a 6% drop in the stock price the day after earnings, followed by a small climb in the subsequent days—primarily attributed to concerns over the scale of investment by Microsoft in developing its AI capabilities. As a long-term Microsoft bull, I believe this tepid response is overly focused on short-term concerns and overlooks the significant progress Microsoft has already made in AI—progress that is now showing clear signs of paying off. Hence, my bullish position on the stock.
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In this article, I’ll take a closer look at Microsoft’s heavy AI investments, drawing insights from its most recent quarterly report, and explain why I believe the stock is a buy right now.
What Has Been Bugging Microsoft Investors Lately?
Much of the recent skepticism surrounding Microsoft’s growth story, particularly concerning AI, has centered on the company’s heavy investments, which have not yet translated into improved margins for its most profitable segment: the cloud business. As of Fiscal 2024, Microsoft has accumulated approximately $44.5 billion in capital expenditures (CapEx), marking an increase of over 58% year-over-year.
This concern was heightened by Microsoft’s Fiscal Q1 earnings, where gross margins in the cloud segment fell by 2 percentage points, from 73% to 71%, despite a 22% year-over-year revenue increase. Typically, such revenue growth would be accompanied by rising margins, but in this case, the company’s substantial investments have led to temporary compression in profitability. Moreover, Microsoft has indicated that it expects to spend even more on CapEx in Fiscal 2025 than it did in the recently concluded Fiscal 2024.
The key issue is that if Microsoft’s revenue doesn’t continue to grow rapidly enough to offset these significant investments, margin pressures could persist, raising concerns about the company’s ability to maintain its historical levels of profitability.
Strong Customer Demand and AI Contracts
From a more optimistic perspective, there are several compelling reasons to view Microsoft’s increased AI investments as a positive sign for its long-term growth. First and foremost, it’s clear that Microsoft is experiencing exceptional demand for its AI services, which is neither short-lived nor speculative.
The company is not just seeing sporadic or short-term usage of its AI infrastructure. In fact, customers are committing to long-term contracts. During the most recent earnings call, Satya Nadella highlighted that some of Microsoft’s largest customers are signing multi-year deals—ranging from five to ten years—for AI services. These long-term agreements signal robust and sustained demand for AI technology, crucial for Microsoft’s future revenue growth.
For example, commercial bookings for AI-related services rose 30% year-over-year in Fiscal Q1. This forward-looking spending ensures Microsoft can capture more business and prevent losing customers to competitors like Amazon’s (AMZN) AWS or Alphabet’s (GOOGL) Google Cloud.
Long-term contracts are particularly beneficial because they provide predictable, recurring revenue streams. This enables Microsoft to confidently expand its AI infrastructure and continue making investments. When Microsoft sees its customers, including some of the world’s largest companies, committed to using AI for the long run, it reinforces the idea that AI is not just a passing trend but a fundamental, transformative technology that will drive sustained growth.
AI-Driven Revenue Growth
Another reason I see Microsoft’s increased AI spending as bullish is the impressive revenue growth driven by its AI-related offerings, such as cloud services and tools like Microsoft 365 Copilot. The company is on track to surpass a $10 billion annual revenue run rate for AI next quarter, making it the fastest-growing business segment in Microsoft’s history.
The ability to generate such strong growth from a relatively new technology, especially at the scale of Microsoft, demonstrates that AI is not merely a strategic bet but a core driver of the company’s future profitability. Microsoft is expected to grow its top line at a compound annual growth rate (CAGR) of 13.3% over the next five years. This development should be seen as a major positive for investors.
Strategic Infrastructure Expansion
Lastly, to further support Microsoft’s bullish outlook in the long term, it’s important to highlight the company’s leadership in AI hardware innovation. Microsoft has become the first cloud provider to deploy Nvidia’s (NVDA) Blackwell system, a cutting-edge AI server technology. This positions Microsoft as one of the first to offer its customers access to the latest and most powerful AI computing hardware, keeping it ahead of competitors like Amazon and Google.
The performance gains provided by the Blackwell system, particularly for AI workloads such as large language models (LLMs), are substantial, making Microsoft an increasingly attractive choice for companies looking to build and deploy advanced AI applications. By being first to market with these advanced technologies, Microsoft has the potential to become a leader in the AI cloud space, possibly surpassing AWS’s market share soon. This infrastructure expansion is critical for maintaining its competitive edge as AI adoption accelerates across industries.
Microsoft’s Rich Valuations Are Likely Justified
Strong advancements in AI have made Microsoft a strong buy. But aren’t the shares’ valuations relative rich to the rest of the market? They are, but for very good reasons, in my opinion.
Take cash flows, for example, which are especially important for major AI players making substantial capital expenditures. Microsoft trades at a price-to-cash-flow ratio of 25.9x, higher than Amazon’s 19.6x and Alphabet’s 21x. However, this premium is likely justified by the company’s diversified revenue streams, best-in-class margins, and exceptional ability to generate free cash flow.
In Fiscal 2024, even with a 58% year-over-year increase in CapEx, Microsoft ended the year with $74.07 billion in free cash flow, marking a 24.5% increase compared to the previous year. This highlights that Microsoft’s cash generation is not being compromised by its investments. Given the competitive advantages mentioned earlier, I expect these investments to yield even greater returns in the coming quarters, reinforcing the company’s strong financial position.
Is MSFT A Buy, According to Wall Street Analysts?
At TipRanks, MSFT stock has a Strong Buy rating based on 26 Buy recommendations and three Hold recommendations among 29 analysts. The average price target is $495.33, suggesting a potential upside of 17.23%.
Conclusion
I believe there is an exaggerated skepticism surrounding Microsoft’s AI investments and their potential impact on the company’s margins, which is why I view the stock as an attractive Buy right now.
While these concerns are valid—investing heavily in AI over a short period is risky, not just for Microsoft but for other tech companies as well—I believe it would be far more concerning if Microsoft weren’t investing in AI, especially given the clear signs of growing demand. Allowing competitors to capture customers driven by AI innovations would present a greater risk.
