While Microsoft's stock experienced its largest single-day drop since 2020, Morgan Stanley firmly stands with the buyers. Despite a sell-off triggered by Azure's growth missing market expectations, Morgan Stanley argues that investors are overly focused on a single metric, overlooking the broader growth picture: a giant with over $240 billion in revenue achieving 15% constant currency growth, operating margin expansion of 160 basis points to 47%, EPS growth of 21%, and a 39% year-over-year increase in cRPO (remaining performance obligation) signaling even stronger future performance.
Microsoft's Q2 FY26 results released on Wednesday showed Azure constant currency growth at 38%, merely 1 percentage point above the company's guidance and falling short of the 2-3 percentage point beat investors had anticipated. This outcome disappointed the market, sending Microsoft's stock plummeting over 12% intraday before closing down 9.99% at $433.50, marking its largest closing decline since March 2020.
However, Morgan Stanley maintained its "Overweight" rating and $650 price target on Microsoft. According to trading desk sources, analyst Keith Weiss noted in a report on the 29th that Microsoft's commercial cRPO grew 39% year-over-year, with total commercial RPO reaching $625 billion—a 110% increase. Even excluding the large OpenAI contract, RPO still grew 28%, indicating broad-based commercial demand strength. CFO Amy Hood emphasized during the earnings call, "Customer demand continues to exceed our supply capacity."
Morgan Stanley believes that, trading at approximately 21 times CY27 estimated P/E, the revenue durability embedded in Microsoft's bookings and the margin expansion potential demonstrated this quarter remain undervalued by the market. Weiss wrote in the report:
"For a stock trading at 21x our CY27 EPS estimate, 21% constant currency EPS growth should be supportive of the share price."
Azure is constrained by supply, not demand, with management prioritizing long-term positioning. Microsoft CFO Amy Hood repeatedly emphasized supply constraints, not weak demand, during the earnings call. "Our customer demand continues to exceed our supply capacity," Hood stated, adding, "If I had allocated all the GPUs that came online in Q1 and Q2 to Azure, that KPI growth rate would have exceeded 40%."
Morgan Stanley points out this reveals the true constraint on Azure's growth. In a supply-constrained environment, Microsoft's ability to beat expectations largely depends on the pace of capacity expansion, which may be less variable than investors assume. More importantly, Microsoft's management is making allocation decisions, balancing Azure growth against first-party applications like M365 Copilot and internal R&D needs. "While investors may be frustrated by the near-term impact, we believe this is the correct long-term decision," Weiss wrote in the report. Morgan Stanley views the M365 Commercial Cloud business as the cornerstone of Microsoft's commercial success, with M365 Copilot poised to transform Microsoft from a productivity solutions provider into the primary user interface for enterprise AI.
Microsoft's Q3 guidance for Azure constant currency growth of 37%-38% implies a sequential performance ranging from flat to down just 1 percentage point—a solid outcome given a 4 percentage point more difficult year-over-year comparison. Morgan Stanley expects that if Microsoft can deliver a slight beat to around 39%, Azure growth could actually accelerate.
The M365 Copilot inflection point is approaching, with 15 million paid seats just the beginning. While the M365 Commercial Cloud's 14% constant currency growth appears similar to the previous two quarters, the underlying drivers are shifting significantly. Microsoft disclosed it now has 15 million paid M365 Copilot seats, with daily active users growing tenfold year-over-year, while the total M365 commercial user base exceeds 450 million. Morgan Stanley notes that although seat growth slowed to 6%, the sustained 14% overall growth implies ARPU is becoming the core contributor. More critically, while E5 upgrades were the primary driver of ARPU growth in Q2, Copilot was listed as the foremost driver of ARPU growth in the Q3 forward guidance, "marking an inflection point." According to Morgan Stanley's January 14th CIO survey, 80% of CIOs said their organizations are using or expect to use M365 Copilot within the next 12 months, up from 72% in the Q2 survey. Penetration depth is expected to reach 36% of users within the next 12 months, up from 31% previously. Based on 15 million paid seats, accounting for volume discounts, this could imply an annual run-rate revenue exceeding $3 billion. Management stated, "this is still in the early innings of the M365 Copilot product cycle," while Morgan Stanley's survey results "strongly support an accelerating adoption ramp."
Margins exceeded expectations and guidance was raised, with the revenue base broadening. Microsoft's gross margin for the quarter was 68.0%, beating market expectations by 80 basis points; the operating margin was 45.6%, beating expectations by 150 basis points and expanding approximately 160 basis points year-over-year. Operating expenses grew only 4% on a constant currency basis, demonstrating excellent cost control. More importantly, Microsoft raised its full-year operating margin guidance from "roughly flat" to "up slightly." Cloud gross margin was 67%, down 1 percentage point sequentially but exceeding the 66% guidance, as efficiency gains were offset by increased AI investment and higher usage. Commercial bookings grew 228% constant currency, benefiting from the large OpenAI commitment, but the data shows OpenAI constitutes 45% of the commercial RPO balance, meaning over $340 billion comes from other customers, with this portion growing 28% year-over-year. The weighted average RPO duration increased from approximately 2 years to about 2.5 years, and this figure is net of risk adjustments. "The 39% total cRPO growth points to a robust future growth outlook, while the 28% figure demonstrates a broad base of commercial strength," Weiss concluded in the report. He emphasized that investors should not focus solely on the Azure metric but rather see the revenue durability reflected in the bookings.
Valuation is seen as undervalued, with the $650 price target maintained. Morgan Stanley maintains its $650 price target on Microsoft, based on 31 times CY27 EPS of $21.17, a slight decrease from the previous 32x multiple, but with the EPS estimate raised from $20.65. This valuation is in line with large-cap software peers, and while the 1.6x PEG ratio carries a premium to peers, Morgan Stanley believes Microsoft's strong positioning and excellent execution justify this premium. At the time of writing, Microsoft's stock price had fallen to $433 per share.
Morgan Stanley's bull scenario offers an $860 price target, based on 36 times CY27 EPS of $23.76; the bear scenario is $310, based on 16 times CY27 EPS of $19.17. The EPS CAGR from FY24 to FY27 is 19.5% in the base case.
"For a company with a revenue base exceeding $240 billion maintaining 15% year-over-year growth, with operating margin expansion driving 21% constant currency EPS growth, and with 39% cRPO growth hinting at potentially stronger future growth, while Azure missed market expectations by 1 percentage point, the market trading the stock at 21x CY27 EPS seems to be missing the bigger picture," Weiss stated. Morgan Stanley views Microsoft as well-positioned in cloud adoption and AI, with a vast distribution channel and installed customer base, and margin expansion supporting EPS growth. "Over the medium to long term, low-teens revenue growth, operating expense discipline, and strong capital returns should deliver sustained mid-to-high-teens total returns."
Comments