Since August of last year, Microsoft's stock price has declined by approximately 20%. Seeking Alpha analyst Bohdan Kucheriavyi believes this significant drop represents a classic case of emotional mispricing by the market, leading to an undervaluation of the company's long-term investment merits. Throughout the period of declining share prices, Microsoft has consistently reported strong financial results, with both its fiscal first-quarter and second-quarter revenues achieving double-digit percentage growth, repeatedly surpassing market expectations. Despite these solid fundamentals, Microsoft's stock has weakened in recent months. The primary reason appears to be the market's excessive focus on Microsoft's substantial investments in AI infrastructure. Furthermore, rising oil prices due to tensions involving Iran and a deteriorating macroeconomic environment have added pressure on the broader technology sector. Considering Microsoft's substantial backlog of orders and persistently strong demand for cloud computing, its upcoming third-quarter earnings report next week is anticipated to demonstrate continued robust performance.
The market reaction has been severely exaggerated. Following the release of its second-quarter earnings at the end of January, Microsoft experienced a historically sharp decline, yet the operating data for that period was exceptionally strong: revenue increased by 16.8% year-over-year to $81.3 billion, with earnings per share of $4.14, surpassing expectations by $0.22. Cloud business revenue surpassed $50 billion, and the total remaining performance obligation surged by 110% year-over-year to $625 billion. Kucheriavyi emphasized that such rapid order expansion is extremely rare among established technology companies. However, Microsoft acknowledged that the explosion in AI demand has led to a shortage of computing power supply, which has been a significant factor in the recent stock price decline. Due to capacity constraints, the company currently forecasts third-quarter Azure growth, on a constant currency basis, to be in the range of 37% to 38%. Given that this growth rate was 38% in the second quarter, Microsoft's cloud business growth may show a sequential slowdown. A positive aspect is that Azure's third-quarter performance could potentially exceed expectations and may accelerate in future quarters. After all, Microsoft's second-quarter report indicated that demand for computing power continues to outstrip supply, with capacity constraints being the sole limiting factor.
To address the AI computing power shortage, Microsoft has implemented several measures. Last year, Microsoft signed agreements totaling over $60 billion with new cloud service providers such as Nebius, CoreWeave, Nscale, and Lambda to secure external computing capacity. Earlier this month, Microsoft also announced an expansion of its partnership with Nscale to further boost its computational reserves in the future. By leveraging external collaborations, Microsoft can rapidly scale its Azure computing capacity without the need to build new data centers from scratch. If the third-quarter earnings report indicates that this additional capacity is gradually coming online, it would suggest that the production bottlenecks are being alleviated. This would also remove a major overhang that has been suppressing cloud business growth and weighing on Microsoft's stock price.
The performance of Microsoft's other major products is also promising. The number of paying users for M365 Copilot has already exceeded 1.5 million, representing a 160% year-over-year increase. As Microsoft continues to add more features to Copilot, enhancing its capabilities as a powerful AI assistant, the user base has further potential for growth. The third-quarter report may validate this trend. Overall, Microsoft's fundamental business strength has not weakened, and its upcoming third-quarter earnings next week are highly likely to reflect continued steady performance. Current market expectations project Microsoft's Q3 revenue to be $814 billion, a 16% year-over-year increase, with earnings per share of $4.06, representing 17% growth.
What is the outlook for Microsoft's stock price? Microsoft currently trades at a price-to-earnings ratio of approximately 25 times, which is near the low end of its range in recent years. Based on a Discounted Cash Flow model analysis, Kucheriavyi calculates a fair value for Microsoft of $533.80 per share, implying an upside of approximately 26% from the current price. Wall Street analysts are even more optimistic about Microsoft's prospects, with an average price target of $578.92 per share, suggesting a potential upside of 36%. However, Microsoft still faces several challenges: a significant increase in capital expenditures, and computing power constraints potentially limiting cloud business growth. Additionally, nearly 45% of Microsoft's commercial orders are deeply tied to OpenAI, which shows no signs of profitability in the short term, introducing uncertainty into the long-term partnership. Beyond this, ongoing geopolitical conflicts and the risk of shipping disruptions in the Strait of Hormuz, which could exacerbate global recession concerns, also pose risks to Microsoft's operations. Despite these objective risks, Kucheriavyi remains convinced that Microsoft's long-term growth thesis remains intact. Following the short-term market mispricing, this technology leader offers substantial room for valuation recovery and represents a sound investment for medium to long-term portfolios.
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