Microsoft's Q2 2026 earnings report, released on Tuesday, revealed that both revenue and profit exceeded Wall Street's expectations. However, its stock price came under pressure and declined in after-hours trading. The fluctuation in market sentiment primarily stems from a gap between the surge in the company's capital expenditures and the acceleration in the growth of its cloud business.
Microsoft's second-quarter revenue reached $81 billion, a 17% year-over-year increase, surpassing market expectations by 1%. Non-GAAP earnings per share (EPS) were $4.41, up 23% year-over-year and beating market forecasts by 5%. The closely-watched Azure cloud business grew 38% at constant currency, also slightly above the Wall Street consensus of 37%.
Despite robust core performance metrics, investors expressed concern over Microsoft's escalating capital expenditures. Data shows that Microsoft's capital expenditure for the quarter was a substantial $37.5 billion, exceeding the general market expectation by 9%. The market had anticipated that such a massive investment would lead to a more significant acceleration in Azure's growth rate, but the current data failed to immediately satisfy these heightened expectations.
According to a recent Goldman Sachs research report dated January 28, despite facing short-term stock price volatility, Microsoft's current strategy involves sacrificing near-term Azure revenue growth to prioritize computing power needs for its first-party applications (like Copilot) and internal R&D (such as Microsoft AI). Goldman Sachs maintains its "Buy" rating on Microsoft but, considering the uncertainty around the specific timeline for capital expenditure translating into revenue growth, has lowered its 12-month price target from $655 to $600.
The mismatch between capital expenditure and growth has triggered investor anxiety. Goldman Sachs believes the negative reaction in Microsoft's stock price primarily reflects investor concerns over capital expenditures that have exceeded expectations for several consecutive quarters. The $37.5 billion quarterly spend (including finance leases) indicates Microsoft is aggressively building AI infrastructure. However, this investment has not immediately translated into a proportional leap in Azure's growth rate.
Analysis suggests this is actually a strategic trade-off by Microsoft. The company is prioritizing the allocation of valuable computing resources to strategic products like Copilot and internal R&D projects, rather than solely pursuing short-term external Azure revenue. Goldman Sachs believes this strategy will ultimately drive a more strategically significant AI positioning across multiple layers of the technology stack and yield better returns in the medium term.
Azure is facing capacity constraints rather than a lack of demand. Regarding the core cloud business, Microsoft's management indicated that Azure is currently experiencing capacity limitations. Goldman Sachs emphasizes that investors should view Microsoft's Q3 Azure growth guidance of 37%-38% as a "guidance based on capacity allocation capability," rather than a pure reflection of demand. This implies that, with capacity constrained, the performance ceiling for any given quarter is largely predetermined.
The report calculates that if Microsoft had not allocated capacity to first-party applications and internal R&D over the past two quarters, Azure's revenue growth rate could have exceeded 40%. Against this backdrop, as new capacity (such as the Fairwater project) comes online and supply chain constraints ease, Azure is poised for a phase of strong performance. Additionally, the MAIA 200 chip launched by Microsoft on January 26 is seen as a positive signal, with its benchmark tests showing performance superior to competitors' internal chips, which will be a key driver for future gross margin and cost-performance differentiation.
The commercialization path for Copilot is becoming clearer. While cloud infrastructure draws attention, AI monetization at the application layer is accelerating. Microsoft noted that the adoption and usage of Copilot are increasing, with M365 Copilot seat additions growing 160% year-over-year, reaching 15 million paid seats.
Goldman Sachs analysis suggests that Copilot will have a better customer lifetime value to customer acquisition cost ratio (LTV:CAC) compared to Azure revenue. This is primarily due to the product's higher gross margins (stronger pricing power than Azure) and greater customer stickiness. Although the growth guidance for M365 Commercial Cloud has slightly moderated to 13%-14%, this partly reflects new seats joining at a lower Average Revenue Per User (ARPU) (e.g., frontline workers and SMEs). Industry discussions indicate that Copilot's output quality is improving, and its functionality will continue to enhance with the launch of new SKUs and features (like WorkIQ).
Goldman Sachs adjusted its valuation model for Microsoft based on limited visibility into the timeline for capital expenditure translating into revenue growth. The analyst lowered the target price-to-earnings ratio from 32x to 28x, consequently reducing the price target to $600.
The report also outlines key downside risks for Microsoft, including: revenue contribution from the OpenAI partnership falling short of expectations; a prolonged ramp-up time for internal chip production limiting market share gains or gross margin expansion; investment in non-Azure projects exceeding expectations; changes in key leadership; and a more significant shift towards custom software potentially negatively impacting the applications business. For the stock to outperform the market, tangible evidence of Copilot's revenue success, validation points for internal R&D commercialization, and a re-acceleration of Azure growth as new capacity comes online will need to be visible to the market within the next 6 to 12 months.
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