Disappointed Cloud Growth Leads to Microsoft Stock Dip Post Earnings, What's Next?

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$Microsoft(MSFT.US)$'s Azure cloud business revenue growth unexpectedly slowed down in FY24 Q4, accompanied by increasing AI capital expenditures, which has intensified concerns among investors regarding the prospects for significant returns on massive AI investment. This nervous sentiment even outweighed the company's double-digit growth in sales and profits.

Disappointed Cloud Growth Leads to Microsoft Stock Dip Post Earnings, What's Next?

Following the earnings after the market close on Tuesday, the stock price of this tech giant plummeted rapidly post-market, dropping by as much as 8% at one point, but ultimately narrowed the decline.

What's Fueling Market Anxiety?

1. Revenue and Net Income Slightly Beat Wall Street Forecasts, But Growth Both Slows Compared to Last Quarter

$Microsoft(MSFT.US)$ reported revenue of $64.73 billion in FY24 Q4 ending on June 30, 2024, exceeding analysts' expectations of $64.52 billion. However, the YoY growth rate of 15% was slower than the 17% growth rate in the previous quarter. The company achieved a net income of $22.04 billion in the quarter, with an EPS of $2.95, slightly higher than the expected $2.94. However, the net income growth rate of 10% YoY was only half of the previous quarter.

2. Cloud Growth Slightly Miss Expectations

One of the key factors that disappointed the market and led to the sell-off of Microsoft's stock is the slower-than-expected growth of its cloud services. Specifically, Intelligent Cloud (includes Server products and cloud services), which contributed the largest revenue to the company, reported a revenue of $28.52 billion in FY24 Q4, lower than the analyst's expected $28.72 billion. The year-on-year growth rate of 19% not only failed to improve but also slowed down from the previous quarter's 21%. The core part of the AI business, Azure and other cloud services, grew by 29% year-on-year, slightly down from the previous quarter's 31%, making it the first time since FY24 Q1 that the growth rate was below 30%, despite the contribution of artificial intelligence technology to growth increasing from 7% to 8 percentage points.

Microsoft's CFO, Amy Hood, explained at the analyst meeting that the lower-than-expected growth of Azure was due to soft demand for non-AI services in a few European markets and the limits of its AI-related hardware affecting AI capacity.

The dramatic reaction of the stock price indicates that investors are very sensitive to any signs of weakness in the company's most important cloud business, as they fail to see the significant returns brought by the massive AI investments before.This also implies that the payback on investment for AI may take longer than initially anticipated. Brad Reback at Stifel Financial pointed out that:

"There's a segment of the investing community that is hyperfocused on very small changes to the Azure business."

In addition, the cost to run generative-Al workloads can dent near-term margins. According to Bloomberg Intelligence's latest research, increasing Azure sales driven by Al workloads could pressure the company's gross margin, as the infrastructure's lower-margin profile offsets its scale benefits.

Despite Azure Miss, Microsoft Boosts CapEx by a Staggering 78%

Microsoft is placing its bets on artificial intelligence for the future, as evidenced by its multibillion-dollar partnership with OpenAI and its investments in data centers and chips to support AI.

Despite the lack of significant returns from AI investments, this tech giant continues to pour more and more money into the AI field, further increasing the market concern. In the FY Q4 ending June 30, Microsoft's capital expenditures (including finance leases) surged by 78% YoY to $19 billion, also significantly higher than $14 billion in the previous quarter, as the company needed to expand its global data center network and overcome capacity constraints to meet the demand for artificial intelligence.

Looking ahead, Brett Iversen, Microsoft's Vice President of Investor Relations, stated that the company will continue to increase spending to meet strong customer demand. Capital expenditures for the fiscal year 2025 are expected to exceed those of fiscal year 2024, even though capital expenditures for fiscal year 2024 have already exceeded the $50 billion mark.

Microsoft's huge capital spending plan coincides with its rival in the AI field, Google. The stock of Alphabet, Google's parent company was sold off after it announced better-than-expected second-quarter revenue and profit, as investors eager for AI returns worried that the company's high spending on technology infrastructure may be overinvestment, affecting profits and even accelerating the burst of the tech stock bubble.

Although technology giants including $Meta Platforms(META.US)$, $Alphabet-C(GOOG.US)$ , and $Microsoft(MSFT.US)$ all believe that the commercial risks of underinvestment in the AI field are greater than the risks of overinvestment, investors are not reassured, and Wall Street is more eager to see performance visibility.

According to Synovus Trust's senior portfolio manager, Daniel Morgan:

"The street doesn't have a lot of patience. They see you spending billions of dollars and they want to see a pickup in revenue of that amount."

What Wall Street Analysts Are Saying About This Earnings Report

According to analysts at Bloomberg Intelligence, Microsoft holds a strong position in the field of AI, and the company's outlay is seen as critical to gaining market share for AI-related workloads:

"Microsoft's vast array of software applications makesit a key beneficiary of the growing digital transition as companies upgrade legacy IT systems. Afoothold in cloud infrastructure, and its close relationship with OpenAl, put Microsoft in a strong position to capitalize on rising demand for generative Al. Steady growth in high-margin Office applicatiois is a plus, as the cost to run generative-Al workloads can dent near-term margins. The Activision deal boosts Microsoft's gaming portfolio and could add $9-$10 billion in sales in the firstyear, we calculate."

Wells Fargo pointed out that lower-than-expected performance in Q4 was due to the limited upward potential of Azure/AI, as well as the significant increase in cloud COGS/capital expenditure. However, the bank believes that these concerns were alleviated by unexpected comments about Azure's re-acceleration in the second half of the year. As a result, the bank has raised Microsoft's target price from $500 to $515 and maintained a buy rating on the stock.

The latest target prices from Wall Street analysts are as follows, with the rating date after July 30, 2024: