Nearly a week after software stocks plunged in response to earnings reports from industry heavyweights like Microsoft (MSFT 0.36%), ServiceNow, and SAP that were less than perfect, the sector continued to plumb new depths.
The iShares Expanded Tech-Software ETF, which tracks the cloud software sector, fell more than 5% on Tuesday and is now down 13% since Jan. 28.
Investors seem to fear that AI could disrupt the cloud software sector, enabling companies to develop tools in-house that could replace many of the subscription software products they use today, or at least reduce their dependence on them.
The software-as-a-service (SaaS) sector has also historically traded at a sky-high multiple, and investors have been willing to allow these companies to spend generously on share-based compensation, often reporting generally accepted accounting principles (GAAP) net losses. Today, many large, well-known software companies are still losing money on a GAAP basis.
However, Microsoft isn't one of them. The tech giant, which is probably the most diversified of the "Magnificent Seven" companies, is now down 26% from its peak just three months ago.
While the broader sell-off in subscription software stocks makes sense since many of these companies don't have real cash flows to fall back on if their growth potential evaporates, Microsoft still looks rock-solid.
Image source: Getty Images.
What the numbers say
Microsoft's latest earnings report offered little reason to explain the stock's 25% plunge, which has wiped off $1 trillion in its market cap.
Overall revenue jumped 17% to $81.3 billion, paced by 39% growth from Azure, and adjusted earnings per share rose 24% to $4.14. Both those figures beat analyst estimates.
The reason for the sell-off seemed to be a surge in capital expenditures to $37.5 billion, including finance leases, which was up 66% from the year before. That also ate into the company's free cash flow, driving fears that it was overspending on AI infrastructure, including GPUs and CPUs, which are short-lived.
However, management said customer demand continues to exceed supply, suggesting the risk of spending money on those chips is low. Additionally, Azure, which is the core of its AI infrastructure business, is a fast-growing, high-margin segment that's expected to grow 37%-38% in the current quarter.
NASDAQ: MSFT
Key Data Points
Microsoft's cheat code
The central premise of the sell-off in the software sector is that "vibe-coding," meaning using AI to create applications through natural language prompts rather than traditional coding, will disrupt the need for cloud software.
In this scenario, AI start-ups like OpenAI and Anthropic are the big winners, cannibalizing a cloud software industry valued in the trillions of dollars. If that's the case, it shows how valuable their tools are, and that value should translate into billions of profits.
That would be good news for Microsoft. After all, it owns a 27% stake in OpenAI, which is currently worth $135 billion and seems likely to go up as Amazon is discussing a $50 billion investment in OpenAI, and Nvidia is planning its largest-ever investment in OpenAI.
Additionally, Microsoft owns a smaller stake in Anthropic after committing to invest up to $5 billion in the company last November, and it's seeing business scale up from Anthropic as it cited the company as a driver of 23% growth in commercial bookings in the quarter.
Microsoft now has $625 billion in commercial remaining performance obligations (RPO), and while OpenAI accounts for 45% of that, it still has $350 billion from other companies.
While some investors have argued that Microsoft's homegrown AI products like Copilot have disappointed, the company has more ways to win from AI than probably anyone else, given its enterprise software products, cloud infrastructure business, Github coding platform, major stake in OpenAI, and now its relationship with Anthropic.
The stock trades at a price-to-earnings ratio of just 25, meaning it is cheaper than the S&P 500. It's growing revenue in the high-teens, and has a visible runway to double-digit growth for at least the next several quarters.
After the recent sell-off, Microsoft looks like a strong buy.
