Microsoft's quarter shows once again that it must get its growth to spending ratio right
C
CNBC Finance
6 min read
Microsoft topped revenue and earnings estimates in its fiscal 2026 second quarter. But shares slid Wednesday evening as Azure failed to deliver meaningful growth upside. In-line guidance did little to change that narrative, which has been hurting the stock. Revenue increased about 16% year over year to $81.28 billion, beating the Street consensus estimate of $80.26 billion, according to data from LSEG. Earnings per share increased 28% from last year to $4.14, ahead of the $3.97 estimate, LSEG data showed. Quarter EPS excluded $9.97 billion in other income related to OpenAI's restructuring. MSFT 1Y mountain Microsoft 1 year Shares of Microsoft sank 6% in after-hours trading, extending a decline that began three months ago when the company reported a quarter that failed to meet a high bar, lacking material revenue growth upside despite a significant increase in capital expenditures. Bottom line Microsoft's quarter on Wednesday evening did little to shake off that view. Azure revenue growth in fiscal Q2 did technically beat analyst estimates. Investors, however, wanted more growth to justify a 66% year-over-year increase in capital expenditures. Even with the company investing heavily in capacity, management said Azure customer demand exceeded available supply in its on-premises server business. What the company must figure out is how to better allocate its resources to maximize Azure monetization. That, at least, is what the market wants. What gives management the confidence to continue investing is a massive backlog that keeps getting bigger and bigger. Microsoft's Commercial Bookings and Commercial Remaining Performance Obligation (RPO) is getting a lot of attention after hours. Bookings were up 230% year over year, driven by previously announced large Azure commitments from OpenAI and Anthropic. Commercial RPO increased 110% year over year to $625 billion, and roughly 25% of that is expected to be recognized in the next 12 months. While there's some headline risk associated with OpenAI and its ability to pay its bills, recent reports of SoftBank talks to invest up to $30 billion more in OpenAI should ease some fears. Why we own it Microsoft is a core backbone of global productivity thanks to its Office 365 suite and hybrid cloud platform Azure. The company is also proving itself to be a key player in artificial intelligence tools. Competitors : Amazon , Alphabet , and Salesforce Weight in portfolio : 2.87% Most recent buy : Aug. 5, 2024 Initiated : Dec. 4, 2017 In short, it was a solid quarter but not enough upside to change the tide against the stock. We've seen AI companies fall out of favor, only to recapture the market's interest a couple of quarters later. This happened to Alphabet last year. And, the post-earnings move in Meta Platforms shares Wednesday evening suggests it could be next. Microsoft has some issues to sort out to either get more Azure capacity online or to better balance capital expenditure growth to improve margins. The recent stock decline is disappointing, but we're betting CEO Satya Nadella and CFO Amy Hood will figure it out. That's why we're reiterating our buy-equivalent 1 rating and $600-per-share price target. Quarterly commentary Productivity and Business Processes revenue increased about 16% year over year to $34.1 billion, beating estimates by about $640 million. Segment operating income increased 22% year over year to $20.6 billion, beating estimates by about $1.35 billion. Microsoft 365 commercial cloud revenue increased 17% year over year (up 14% on a constant currency basis, which excludes foreign exchange fluctuations). The higher revenue was driven by an increase in revenue per user, thanks to the adoption of the Microsoft 365 E5 enterprise tier and Microsoft 365 Copilot products. Commercial seats also increased 6%. For all the criticism that Copilot gets, seat growth accelerated quarter over quarter to 15 million paid seats. Microsoft 365 consumer cloud revenue growth increased 29% year over year (up 27% in constant currency). LinkedIn revenue was up 11% year over year (up 10% constant currency), and revenue from the Dynamics 365 customer relations and operations suite increased 19% year over year (up 17% constant currency). Intelligent cloud revenue increased roughly 28% year over year, beating estimates by about $500 million. Segment operating income of $13.87 billion exceeded the consensus estimate by about $200 million as margins shrank due to increased AI investments. Revenue growth from Azure and other cloud services ticked down from the prior quarter to 39% year over year, (38% on a constant currency basis). That's about in line with the consensus estimate of 38.4% on a reported basis and 37.8% in constant currency. We suspect the Azure growth numbers were a source of the after-hours disappointment as investors wanted to see a bigger beat to justify all that AI spending. The More Personal Computing segment was the only one that missed revenue expectations, dipping 3% year over year to $14.25 billion, due to lower gaming sales. However, Windows OEM and Devices revenue were stable, and Search and News advertising revenue increased. Despite the revenue shortfall, operating income was a little better than expected. Capital Expenditures , including assets acquired under finance leases, totaled $37.5 billion, up the aforementioned 66% year over year. It was also a $2.6 billion increase sequentially and roughly $850 million more than the consensus estimate. The company said that about two-thirds of this spend was for short-lived assets like GPUs (graphics processing units) and CPUs (central processing units) needed to support Azure's demand, AI solutions, and research and development. Guidance The midpoint of the revenue outlook for Microsoft's fiscal 2026 third quarter was roughly in line with the consensus estimate. In total, the company expects revenue of $80.65 billion to $81.75 billion, which at a midpoint of $81.20 billion edged the consensus of $81.18 billion. By segment, the company guided Productivity and Business Processes and Intelligent Cloud revenue above estimates, while More Personal Computing missed because of excess personal computer inventory. The key line within Intelligent Cloud was Azure, and CFO Amy Hood guided revenue growth on a constant currency basis to 37% to 38%. That's about in-line with the Street estimate of 37% but represents another down tick from 38% in the reported quarter. At least capex isn't expected to be as high next quarter. Those investments are expected to decrease on a sequential basis "due to the normal variability from cloud infrastructure build-outs and the timing of delivery of finance leases." 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