Share prices of Microsoft (MSFT +2.20%) were down 6% immediately following its fiscal second-quarter earnings report on Jan. 29. The software leader delivered revenue and earnings that topped Wall Street's expectations, but it wasn't enough for investors to justify bidding the share price to new highs.
The main issue seems to be valuation. Microsoft has accelerated its capital expenditures over the past few years to support artificial intelligence (AI) initiatives. Investors have bid the share price up to a high price-to-earnings (P/E) multiple of 33 anticipating those expenditures to drive strong growth, but the company's earnings have increased just 10% year over year for the last three quarters.
Investors may be starting to lose patience waiting for these investments to pay off. Here's why the stock could continue to disappoint investors in 2025.
NASDAQ: MSFT
Key Data Points
Higher capital spending is not translating to higher growth
To its credit, Microsoft is in a solid competitive position to benefit from enterprise investment in AI services. Microsoft's cloud revenue surpassed $40 billion and grew 21% year over year. AI-related revenue is up to $13 billion on an annualized basis, and up 175% year over year.
Still, the revenue from AI is barely moving the needle for a company generating $261 billion in total revenue across all products. Moreover, as its relatively low rate of earnings growth indicates, this small amount of additional AI revenue is coming at a big cost.
Data by YCharts.
Microsoft doubled its data center capacity over the past three years. Capital expenditures during calendar 2022 were under $25 billion but have more than doubled to $55 billion over the past 12 months.
Despite this accelerated spending curve, Microsoft's year-over-year earnings growth has slowed from over 20% a year ago to just 10%, and this deceleration in earnings growth comes as investors are paying a higher P/E multiple for the shares. Even considering long-term estimates, analysts expect earnings to grow at an annualized rate of 13%, which may not be enough to support the stock's 33 P/E.
It's understandable that higher spending will pressure near-term margins and earnings. But even Microsoft's revenue growth hasn't shown any acceleration over the past five years. Microsoft's 12% year-over-year increase last quarter is consistent with its historical average.
This raises questions about whether Microsoft is earning the returns on capital to justify these massive spending increases in technology infrastructure.
The stock is relatively expensive and could fall further
To be fair, Microsoft is investing to meet demand for AI and cloud services over the long term. But that doesn't make the stock a buy, especially when there are other top tech companies investing in AI but also reporting much higher earnings growth.
For example, Meta Platforms reported Q4 earnings growth of 50% year over year, and analysts are also forecasting its earnings to grow 17% annually over the next several years. Meta is growing earnings faster than Microsoft, while the stock's valuation is slightly cheaper. Investors can buy shares for 29 times earnings.
Microsoft is certainly seeing robust demand for AI, but AI services are not generating enough revenue to make an impact on the company's overall growth rate. Unless Microsoft can accelerate revenue or earnings growth, investors shouldn't expect the stock to hit new highs anytime soon, and there could even be more downside if the stock corrects to a lower P/E.
