Microsoft is currently facing a cold shoulder from Wall Street. Over the past few months, the company's stock has consistently underperformed the S&P 500 index; a massive sell-off triggered by last Wednesday's earnings report drove its price-to-earnings ratio down to its lowest level since 2022. This investor reaction stems from concerns over the growth slowdown of its closely watched cloud business, Microsoft Azure, while overlooking the bigger picture.
Microsoft's Chief Financial Officer, Amy Hood, indicated to analysts last week that Azure's growth could have been more robust this quarter if the company had secured more computational resources. However, Microsoft prioritized allocating the bulk of its computing capacity to its enterprise software business. This strategy is entirely reasonable: the software division is Microsoft's largest and most profitable segment, maintaining a stable gross margin of approximately 81%. In contrast, the gross margin for the Microsoft Intelligent Cloud unit is about 20 percentage points lower and is on a declining trend. This implies that Azure's expansion is exerting downward pressure on the company's overall gross margin.
Nevertheless, the growth from the software business is capable of offsetting this pressure, and Microsoft is successfully executing this balancing act. Since the introduction of new AI services, Microsoft's overall gross margin has remained stable at around 68% over the past few years. Concurrently, the company has maintained impressive cost control. As noted by Jackson Ader, a software analyst at KeyBanc Capital Markets, Microsoft's operating margin has steadily improved since it first launched its AI software suite, Microsoft Copilot, in early 2023, climbing from about 41% then to over 47% today.
Microsoft's heavily promoted AI-powered software products, such as Office 365 Copilot, appear to be yielding significant results. Company executives disclosed last week that Microsoft Copilot reached 15 million paid subscribers in the fourth quarter, a 160% year-over-year increase. While this figure still represents a small portion of the overall business—Microsoft Office had a total of 400 million paid users as of 2024—it already far surpasses the subscription base of Google's Gemini Enterprise edition. Ader's recent survey of software resellers revealed that 31% of their clients are showing strong interest in the AI assistant "GitHub Copilot," embedded within Microsoft's development tools.
It is noteworthy that the revenue growth rate for Microsoft's core Productivity and Business Processes segment has accelerated significantly in the first half of the current fiscal year. The segment's full-year revenue growth for fiscal 2025 was 13%, but this has increased to approximately 16% in the first half of this fiscal year.
However, as of last Friday, Microsoft's enterprise value multiple stood at 15.2 times its estimated EBITDA for the next year, which, according to Koyfin data, is below its historical average of 15.2 times since early 2021. This valuation also represents a discount compared to a peer, the much smaller enterprise software company ServiceNow. Furthermore, ServiceNow's profitability pales in comparison to Microsoft's: its operating margin is only in the low double-digits, whereas Microsoft's operating margin exceeds 40%.
Bullish investors on Microsoft argue that the current moment presents a "good opportunity to buy Microsoft." Mark Malek, Chief Investment Officer at wealth management firm Siebert Financial and a Microsoft investor, suggested the sell-off was "something of an overreaction." He stated that considering Microsoft's 28% earnings per share (EPS) growth, coupled with its product portfolio and brand strength, the company's operational performance is "extremely outstanding."
Bearish perspectives on Microsoft primarily revolve around uncertainties surrounding the future of its software business, which contributes over half of the company's profits. New AI tools from established software firms and startups could potentially challenge Microsoft's existing enterprise software products.
Microsoft has chosen not to release the new 365 Copilot features as a standalone product but has instead integrated them into the existing Office 365 suite. This means customers must pay a higher cost to access these features. Enterprises unwilling to pay for this add-on service can opt for a pay-per-use model for the Copilot chat service, but they may find this approach ultimately more expensive. The challenge for Microsoft lies in ensuring that companies do not simply replace existing software with AI products while maintaining their overall spending on Microsoft software.
Another issue is whether Microsoft can keep pace with emerging competitors. Tomasz Tunguz, General Partner at venture firm Theory Ventures, remarked on Thursday that while Microsoft Copilot had an "early lead," it is now "starting to show signs of falling behind." He cited the strong innovative momentum of Anthropic's Claude collaboration tool and the code assistant Cursor, suggesting that "Microsoft's pace of innovation is much slower than others, lacking sustained developmental momentum." He also expressed a reasonable concern that an increasing number of enterprises might be reluctant to upgrade to Copilot in the future.
However, Microsoft possesses a powerful first-mover advantage, making it unlikely for enterprises to rapidly switch to competitors. This means Microsoft still has time to catch up. Copilot allows users to choose different AI models, meaning customers can benefit from innovations in new models through software integrated into Microsoft's existing products. This factor would give customers pause before deciding to switch to a competing service.
For investors skeptical about the prospects of Microsoft's software business, the company's cloud operations offer another reason to consider buying. Siebert Financial's Malek indicated that his optimistic outlook for Microsoft stems more from the long-term infrastructure build-out behind Azure—where demand significantly outstrips supply—than from confidence in its software business.
Regarding Azure, Microsoft faces the same risks as other major cloud providers: the need for massive capital investment to build AI data centers equipped with vast numbers of graphics processing units. Whether these companies will achieve substantial returns on this investment remains uncertain.
But Malek believes Microsoft is better positioned than most. "We understand this is a capital-intensive business. They have the revenue to support it, and the cash on their balance sheet to back it up. Companies like CoreWeave are also building infrastructure, but they lack Microsoft's revenue scale and don't have a large, mature platform like Microsoft's to support them," Malek stated. CoreWeave is an emerging cloud services company attempting to compete with major cloud providers in the AI space.
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