By Dan Gallagher
Big tech's AI champ is looking a little battered these days.
Microsoft was an early mover on generative artificial intelligence, and investors benefited handsomely. The software company's stock surged nearly 57% last year in its best annual performance since 1999, according to FactSet data. But the cold splash of reality that AI stocks have received over the past few months has been particularly chilling for the company that helped introduce the world to ChatGPT. Microsoft's year-to-date performance of less than 11% lags behind all other megacap techs and the S&P 500. It is also the only one in that crew to trail the Dow Jones Industrial Average for the year.
There is a mix of reasons. Microsoft's business is indeed booming. Revenue of $245.1 billion for the fiscal year that ended in June was up nearly 16% from the previous year and a record, while the company's annual operating margin of 44.6% for the year was its highest since 2001 -- when the business was about 10% of its current size -- according to data from S&P Global Market Intelligence.
But keeping its lead in the AI race is proving expensive -- even for a company of Microsoft's vast resources. Big tech companies have boosted spending on AI technology across the board, but Microsoft's surge still catches the eye. Capital expenditures combined with equipment leases totaled $55.7 billion in the recently ended fiscal year. That is 23% of the company's reported revenue for the year, up from just 14% of revenue over the previous five years.
That outlay likely isn't an anomaly. Microsoft Chief Financial Officer Amy Hood said during the company's last earnings call in July that capital spending would increase again this year. Analysts expect total capital spending to represent 28% of Microsoft's revenue this fiscal year and 27% in the next fiscal year, according to estimates from Visible Alpha.
That spending has a cost. Analysts expect Microsoft's free cash flow to rise only 3% this year compared with a 25% jump the previous year. And since a lot of that spending will be going to AI infrastructure -- like Nvidia's expensive chips and the liquid cooling systems required for the latest of them -- Microsoft will also face higher depreciation charges against its earnings. In an Oct. 3 report, Keith Bachman of BMO Capital Markets said Microsoft's "elevated levels of capex and thus depreciation may limit margin expansion in the near and medium term."
There is also the question of what that spending will actually yield. Microsoft has so far not disclosed specific revenue from generative AI offerings such as its Copilot tools, though Hood said in the last call that the 29% year-over-year revenue growth for the company's Azure cloud service in the latest quarter included 8 percentage points from AI services. Keith Weiss of Morgan Stanley wrote in an Oct. 1 report that "investor patience appears to be wearing thin for GenAI to inflect revenue growth trend-lines more positively in the space."
Recent financial reporting changes by Microsoft might shed a little more light on the matter -- or less. The changes, announced on Aug. 21, shift revenue around the company's business segments and will effectively lower revenue for the closely watched Azure cloud business but also boost the reported growth rates there, according to an analysis by Mark Moerdler of Bernstein.
Microsoft says the changes were made to better reflect how the affected businesses are actually managed. But they will also make comparisons with prior periods difficult. "When Microsoft reports [fiscal first-quarter results], it will be difficult to discern what's really happening," John DiFucci of Guggenheim wrote in a report last month. And Microsoft has a complicated business model already -- made up of a mix of cloud contracts, transactional software licensing, game console and device sales and advertising. "In other words, Microsoft is not an easy business to understand and these periodic changes make that much more difficult," noted Moerdler.
Microsoft's perceived dependence on OpenAI might also be a bit of a liability. The company participated in the latter's mammoth fundraising round that closed this last week and previously invested $13 billion -- making it OpenAI's largest outside stakeholder. But OpenAI is also experiencing a new bout of turmoil, with several high-profile executives recently departing as the outfit begins a shift toward becoming a for-profit company.
The close partnership with ChatGPT's developer also hasn't insulated Microsoft from worries about its competitive position. In a rare downgrade of the stock to a neutral rating, Gil Luria of D.A. Davidson said that "competition has largely caught up with Microsoft on the AI front, which reduces the justification for the current premium valuation." About 93% of analysts rate the stock as a buy, indicating that Wall Street is still inclined to give the $3.1 trillion software giant the benefit of the doubt. Microsoft just has to make sure those doubts don't grow.
Write to Dan Gallagher at dan.gallagher@wsj.com
(END) Dow Jones Newswires
October 06, 2024 08:30 ET (12:30 GMT)
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