The Nasdaq Composite index has been scorching hot this year, returning 35% in 2023 as of the time of this article. While many technology companies resorted to layoffs and tight budgets in an effort to return to profitability, the hype around artificial intelligence (AI) has brought a lot of momentum to the sector.
Microsoft (MSFT -0.18%) wasted no time taking advantage of the AI trend, notably making a multibillion-dollar investment in ChatGPT parent OpenAI earlier this year. Following the investment, Microsoft integrated generative AI into its search platform, Bing.
More recently, the company announced a subscription service called Copilot, which leverages AI across the company's suite of Office products such as Word, Excel, PowerPoint, and Teams. Microsoft's aggressive innovation in its race against tech counterparts such as Alphabet and Amazon has helped fuel the stock throughout much of 2023. However, the double-edged sword here is that investor expectations going into earnings were sky-high.
While the company reported solid results all around, its outlook did not meet investor demands. Subsequently, the stock cratered and is now down roughly 7% since the earnings release. Despite its outlook, I see the sell-off as overblown and believe now is a great buying opportunity.
Earnings were a mixed bag
The image below illustrates Microsoft's revenue and profit results for its fiscal 2023's fourth quarter, ended June 30. Total revenue rose 8% year over year to $56.2 billion, beating Wall Street expectations. The company's gross profit grew 11% to $39.4 billion, while its gross margin expanded 200 basis points to 70%.
Microsoft's revenue growth and margin expansion flowed to the bottom line as the company also beat on earnings-per-share (EPS) estimates. Microsoft reported $2.69 EPS against expectations of $2.55 per share, and the company grew its free cash flow 12% year over year to $19.8 billion.
Given the top- and bottom-line beats, investors may be curious why the stock price declined precipitously following the report. For that, it will be important to assess Microsoft's cloud growth and management's outlook.
Why did the stock drop?
Per the infographic above, Microsoft's intelligent cloud segment generated $24 billion in revenue, which was a 15% year-over-year increase. This includes server products and the company's Azure cloud platform. While server products revenue increased 17% year over year, it was the 26% growth from Azure services that really helped fuel intelligent cloud.
After a deep dive into the company's earnings, I found two items I believe may have influenced the stock's sell-off. First, management guided for Q1 fiscal 2024 intelligent cloud revenue of $23.3 billion to $23.6 billion, with Azure growing between 25% and 26%. Although this is healthy growth, it is not the most exciting picture when comparing to the results above.
In addition, a comment on next year's growth by the company's CFO, Amy Hood, may have discouraged some investors when she said that "increased capital spend will drive higher COGS [cost of goods sold] growth than in FY23" and that "we expect full year operating margins to remain flat year-over-year."
Should you buy the stock?
Some investors may have been let down by management's guidance. However, it is important to keep in mind that even though inflation is cooling, the Federal Reserve is still raising rates, thereby causing consumers and corporations alike to remain cautious when it comes to spending.
Management also made it clear that while AI is already contributing to the business, it is going to take time to scale in a meaningful way. It may not be in an investor's best interest to punish a stock based on variability in growth between quarters. AI is still very much in its infancy, and hefty investments are a fundamental part of a company's growth.
The current consensus estimate for Microsoft stock is roughly $360, implying 10% upside from current levels. Microsoft shares trade at a forward price-to-earnings (P/E) ratio of 30 and a price-to-sales (P/S) ratio of 11.9. By comparison, Alphabet trades at a forward P/E of 23 and a P/S multiple of 5.9.
While Microsoft stock trades at a premium compared to one of its closest cohorts, the recent price action serves as a tempting opportunity to buy the dip. A prudent investment strategy would be to dollar-cost average into Microsoft stock over time while keeping a keen eye on its AI roadmap.
