The spending is not expected to slow down, Microsoft CFO Amy Hood said during the company’s July earnings call that capital spending would rise again this year
Microsoft, once seen as a leader in generative artificial intelligence (AI), is now facing growing challenges despite its early successes. Last year, the tech giant’s stock surged nearly 57%, its best performance since 1999, largely driven by the excitement around AI, especially its partnership with ChatGPT. This year, however, the excitement has cooled. With less than 11% growth so far, Microsoft’s stock is trailing behind other major tech players and even the broader S&P 500.
The company’s financials remain strong, with revenue reaching a record dollar 245.1 billion for the fiscal year ending in June, a nearly 16 per cent increase from the previous year. Operating margins hit 44.6 per cent, the highest since 2001, a significant achievement for a company that has grown tenfold since then. But maintaining its edge in AI is becoming expensive, even for a company of Microsoft’s size. Its capital expenditures, combined with equipment leases, totaled Dollar 55.7 billion for the year, a figure representing 23 per cent of its total revenue. This is a notable jump from the 14 per cent average over the previous five years.
This spending is not expected to slow down. Microsoft CFO Amy Hood said during the company’s July earnings call that capital spending would rise again this year. Analysts predict that capital expenditures will account for 28 per cent of Microsoft’s revenue this fiscal year and 27% the next, according to estimates from Visible Alpha. While this investment is aimed at AI infrastructure, including expensive chips from Nvidia and the liquid cooling systems they require, it comes with a cost. Free cash flow is expected to grow by just 3 per cent this year, a sharp drop from the 25 per cent rise last year. Higher depreciation charges are also anticipated, limiting margin growth in the near term.
“What’s really happening is that elevated levels of capex and thus depreciation may limit margin expansion in the near and medium term,” said Keith Bachman of BMO Capital Markets in an Oct. 3 report.
Microsoft has yet to reveal specific revenue figures from its generative AI offerings, including its Copilot tools, but the AI component is clearly part of its growth. Amy Hood mentioned that 8 percentage points of the 29 per cent year-over-year revenue growth for the Azure cloud service came from AI services. However, some analysts are starting to question the returns on these investments. Keith Weiss of Morgan Stanley noted that “investor patience appears to be wearing thin for GenAI to inflect revenue growth trend-lines more positively in the space.”
Recent changes to Microsoft’s financial reporting could either clarify or obscure the picture. The company announced in August that it would shift revenue around its business segments, which will reduce reported Azure revenue but increase growth rates for the unit, according to an analysis by Mark Moerdler of Bernstein. While Microsoft says the changes better reflect how these businesses are managed, they will make comparisons with previous periods difficult. “When Microsoft reports [fiscal first-quarter results], it will be difficult to discern what’s really happening,” wrote John DiFucci of Guggenheim.
Adding to Microsoft’s complications is its close partnership with OpenAI, the company behind ChatGPT. Microsoft has invested dollar 13 billion in OpenAI, making it the largest outside stakeholder. However, OpenAI has experienced turmoil, with several high-profile executives leaving as the company shifts towards a for-profit model. This connection has not shielded Microsoft from concerns about its competitive position. In a rare move, Gil Luria of D.A. Davidson downgraded Microsoft’s stock to neutral, stating, “Competition has largely caught up with Microsoft on the AI front, which reduces the justification for the current premium valuation.”
Despite the concerns, Wall Street remains largely optimistic, with about 93% of analysts still rating Microsoft as a buy. However, the company will need to ensure that investor doubts don’t continue to grow.