Microsoft (MSFT 10.23%) just reported fiscal second-quarter results, and the software and cloud giant offered one especially telling signal about demand for its commercial products, largely driven by a growing appetite for AI (artificial intelligence)-capable cloud computing: the software giant's commercial remaining performance obligations soared to $625 billion.
The more than doubling of this figure year over year is reassuring for investors. Microsoft is spending heavily to expand compute capacity for AI and cloud workloads, so a healthy pipeline of contracted demand is a key part of the story. But does a soaring backlog like this really reflect how Microsoft's revenue can inflect over time? Or is it possible that the company sees very little acceleration in its business, despite a surge in commercial remaining performance obligations (RPO)?
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Microsoft's surging backlog
Why watch Microsoft's commercial RPOs?
Microsoft's commercial RPOs represent the dollar value of contracted commercial work that has not yet been recognized as revenue. They're a key indicator of demand for Microsoft's services. And, lately, the AI boom has provided a huge tailwind for this key metric.
In its fiscal second quarter, Microsoft said commercial remaining performance obligations rose 110% to $625 billion. Not only was this a big sequential increase from $392 billion in fiscal Q1, but it also marked a significant step-up in the speed at which Microsoft's backlog is growing. Microsoft's 110% year-over-year increase in commercial RPOs in fiscal Q2 was more than twice its 51% growth rate in fiscal Q1.
4 reasons to be skeptical
With this said, there are four reasons investors should view this backlog cautiously.
First of all, it's worth emphasizing that this is contracted work, not guaranteed revenue. On the same note, RPOs represent multiyear demand, meaning that this contracted work will take substantial time to convert into actual revenue. Indeed, Microsoft said in its fiscal second-quarter update that the portion of its commercial RPOs it expects to recognize over the next 12 months grew much more slowly than its total commercial backlog, rising 39% year over year. And the company said only 25% of its total commercial RPOs are expected to be recognized in the next 12 months.
Second, investors should note that a huge portion -- 45% to be exact -- of Microsoft's commercial backlog comes from a single customer: OpenAI. This means there's customer concentration risk to Microsoft's backlog. And this customer concentration risk is even more severe than it looks, since the company's commercial RPOs, when excluding OpenAI, are growing much slower -- at a rate of 28% year over year.
Third, even though its commercial RPOs are accelerating recently, Microsoft's "Azure and other cloud services" revenue -- the segment that includes the company's cloud computing business -- actually saw a decelerated growth rate in fiscal Q2, growing 38% year over year in constant currency compared to 39% constant-currency growth the prior quarter. Translation: Just because Microsoft's commercial backlog growth is accelerating doesn't mean the company will be able to convert it into revenue at a more rapid rate.
And the fourth and final reason to be cautious about Microsoft's commercial RPOs is that the company's big growth in cloud demand has been accompanied by a surge in spending. Microsoft's capital expenditures in fiscal Q2 came in at $37.5 billion -- up 66% year over year.
The bull case is that Microsoft's significant spending to build out its cloud computing business will eventually accelerate the company's ability to convert its swelling commercial RPOs into revenue, and that this revenue stream will be highly profitable.
The bear case is that not only does it take longer than anticipated to convert its commercial RPOs into revenue, but also that the economics of this contracted revenue are poor, weighing on Microsoft's margins.
Of course, there are a bunch of scenarios in between these bull and bear cases, too.
NASDAQ: MSFT
Key Data Points
In short, there's significant uncertainty associated with Microsoft's backlog. So even though it is a sign of vibrant demand, investors would probably be better off focusing on Microsoft's financial results today rather than speculating about the future. For now, we see a company that grew its revenue 17% year over year in fiscal Q2, with non-generally accepted accounting principles (non-GAAP) earnings per share rising 24% year over year. For a company with a price-to-earnings ratio of about 27 as of this writing, this is impressive.
So, ultimately, Microsoft stock looks attractive at its current valuation, but not because of its backlog. Rather, because of its recent results combined with the stock's reasonable valuation. With this said, given its soaring capital expenditures, investors should view the software and cloud computing giant as a high-risk stock and should consider keeping any allocation to it small.
