Shares of Microsoft (MSFT 1.39%) have slipped since last week's earnings release. As of this writing, the stock is down about 6% from the Oct. 29 report, even though results topped expectations and cloud growth accelerated. Pullbacks like this (when shares fall even as the operating story looks impressive) deserve scrutiny.
The software giant's latest report showed broad-based strength, led by cloud and artificial intelligence (AI) demand. And the dip came for a simple reason that isn't about demand at all: Investors balked at how much capital the company is plowing into AI capacity.
But this raises the question: Why is Microsoft investing so aggressively? Perhaps it is because it sees evidence that its AI investments are yielding strong business results. And if that's the case, this may be an ideal time to buy the stock.
Image source: Getty Images.
Momentum in the numbers
Microsoft's revenue rose 18% year over year to $77.7 billion in the first quarter of its fiscal year 2026, ended Sept. 30. Operating income increased even faster, rising 24%. These two factors helped adjusted earnings per share rise 23%.
Capturing Microsoft's momentum is its growth in cloud-based business (or, as the company calls it, Microsoft Cloud), which is benefiting from surging demand for AI features and services. Total revenue from Microsoft's cloud-based business reached $49.1 billion -- up 26% year over year. Azure (Microsoft's cloud-computing business), in particular, stood out. Revenue from Microsoft's Azure and other cloud services rose 40% year over year.
But the company wasn't depending entirely on cloud for growth. There were other areas of strength as well. One key highlight is its productivity and business processes revenue, which grew 17% due to continued Microsoft 365 adoption.
"We delivered a strong start to the fiscal year, exceeding expectations across revenue, operating income, and earnings per share," Microsoft CFO Amy Hood said in the company's fiscal first-quarter earnings release.
In the same release, CEO Satya Nadella noted that AI integration across its products and services "is driving broad diffusion and real-world impact." This explains "why we continue to increase our investments in AI across both capital and talent to meet the massive opportunity ahead," he added.
Capex jitters vs. growing demand
Why has the stock pulled back if the business looks this healthy? Capital intensity.
Management's capital expenditures (capex) during the quarter surged to about $35 billion, driven by AI infrastructure investment to support increasing demand for its cloud and AI offerings -- and management commentary signaled spending will increase even more to alleviate capacity constraints and capitalize on growth opportunities.
"With accelerating demand and a growing [remaining performance obligations] balance, we're increasing our spend on GPUs and CPUs," Hood said during the company's fiscal first-quarter earnings call when discussing the company's expectations for capital expenditures. "Therefore, total spend will increase sequentially, and we now expect the [fiscal 2026] growth rate to be higher than [fiscal 2025]."
Such sharp growth in capital expenditures on top of already elevated spending will pressure Microsoft's free cash flow. And, in this case, Wall Street doesn't seem to love near-term free-cash-flow pressure, even when it funds clear demand.
And there is real demand. Not only did Azure's pace outperform expectations, but commercial remaining performance obligations jumped 51% to $392 billion -- a balance that has almost doubled over the last two years.
NASDAQ: MSFT
Key Data Points
Valuation and risk
The near-term risk is not that customers aren't buying; it's that Microsoft needs to build fast enough to serve them while maintaining margin discipline.
Additionally, the stock isn't cheap at today's valuation of 33 times forward earnings. But it's not overpriced either -- especially in light of the company's surging demand and growth in expenditures that management expects to lead to more growth over the long haul.
There is, of course, significant timing risk. Management's outlook implies continued demand strength in the near term, yet the payoff from today's record capex will unfold over a period of years. If, at any point, monetization of its heavy capital expenditures starts to fade, investors could decide that the stock isn't worthy of its premium valuation multiple.
Overall, I believe the recent decline in the stock price is overdone. The one-week slide looks driven more by concerns about Microsoft's plans to fund the future than by cracks in the franchise. As long as Microsoft continues translating AI demand into cloud revenue -- and manages capital expenditures with discipline -- today's pullback could age well.
