Microsoft’s AI journey hits roadblocks

Microsoft, once celebrated as a pioneer in generative artificial intelligence, now finds itself navigating rough waters. Investors who once reaped substantial gains are growing cautious. Despite last year’s impressive 57% stock surge, Microsoft’s performance in 2024 has been underwhelming, trailing behind other tech giants and major indices like the S&P 500 and Dow Jones Industrial Average.

Financial Performance Amid AI Investments

Microsoft’s business remains strong, with a record $245.1 billion in revenue for the fiscal year ending June 2024, marking a 16% increase. The company’s operating margin reached its highest point since 2001 at 44.6%. However, staying ahead in the AI race is proving costly. Microsoft's capital expenditures, including equipment leases, totaled $55.7 billion last fiscal year—23% of its annual revenue, a significant jump from the previous five years.

This surge in spending isn’t expected to slow down. CFO Amy Hood announced plans for further capital expenditure increases this year. Analysts predict these costs will represent 28% of Microsoft’s revenue this fiscal year and 27% the next, highlighting the significant financial commitment required to maintain its AI leadership.

Impact on Cash Flow and Profitability

These investments come at a price. Microsoft’s free cash flow is projected to grow by just 3% this year, a sharp contrast to the 25% growth seen previously. Much of this spending is directed toward AI infrastructure, including costly Nvidia chips and liquid cooling systems, which will increase depreciation charges. Keith Bachman of BMO Capital Markets noted that these expenses might limit Microsoft’s margin expansion in the near and medium term.

Uncertain AI Revenue and Financial Reporting Changes

The return on these hefty investments remains unclear. While Microsoft hasn’t disclosed specific revenue from its generative AI products like Copilot, CFO Hood mentioned that AI services contributed 8 percentage points to the 29% year-over-year growth of Azure cloud services. However, investor patience is waning, with expectations for AI to significantly boost revenue growth.

Recent changes in Microsoft’s financial reporting add another layer of complexity. Announced on Aug. 21, these changes redistribute revenue across business segments, lowering Azure’s reported revenue but increasing its growth rates. While intended to reflect management practices more accurately, these changes complicate comparisons with previous periods. As John DiFucci of Guggenheim highlighted, it will be challenging to gauge Microsoft’s true performance when the first-quarter results are reported.

Concerns Over OpenAI Relationship

Microsoft’s heavy investment in OpenAI, including a recent fundraising round and a previous $13 billion investment, underscores its commitment to AI. However, OpenAI’s recent executive departures and shift towards a for-profit model raise concerns. Microsoft’s close ties with OpenAI haven’t shielded it from competitive pressures. In a rare downgrade, D.A. Davidson’s Gil Luria rated Microsoft stock as neutral, citing that competitors have caught up in AI capabilities, undermining Microsoft’s premium valuation.

Despite these challenges, about 93% of analysts still rate Microsoft stock as a buy, reflecting continued confidence in the $3.1 trillion software giant. Microsoft’s task now is to address these growing doubts and maintain its leadership in the AI arena.