Microsoft Needs to Show Azure Strength to Stem Great Rotation

(Bloomberg) -- After more than a $2-trillion Nasdaq 100 wipeout, investors are nervously awaiting Microsoft Corp.’s earnings report to see whether the software maker can turn the tide.

Traders are increasingly concerned that tech firms aren’t yet seeing returns from heavy investments in artificial intelligence. Shares in Alphabet Inc. slid last week after the Google parent reported higher-than-expected spending, adding to a broader selloff for Big Tech. That’s raised the bar for Microsoft, which is trading at a fairly hefty valuation of about 32 times projected profits and needs to show AI-related spending is translating into sales growth for its Azure cloud business.

“Microsoft has to beat in a big way and they’ve got to show Gen AI monetization,” said Ted Mortonson, managing director at Robert W. Baird, adding that last week’s rout has ramped up the pressure on Tuesday’s results. Microsoft is “the most over-owned name globally, next to Nvidia. So those two really have to put up some good numbers. And you’re going to have to see Azure accelerate above the Street to make it work.”

Before the recent sector selloff, Microsoft stock had gained about 24% this year, while options data is now indicating an implied one-day move — in either direction — of about 4.6%. Microsoft shares fell as much as 2.2% Tuesday. 

The report will kick off a critical week for the sector. The rotation out of megacaps has dragged the Nasdaq 100 Index down more than 8% from its high about three weeks ago. Microsoft will set the scene for reports from Meta Platforms Inc., Apple Inc. and Amazon.com Inc. later in the week, while investors are also awaiting a Federal Reserve interest-rate decision on Wednesday.

Read: Big Tech Earnings Arrive With Nasdaq 100 on Brink of Correction

The key number in Microsoft’s report is sales growth in the Azure unit. Wall Street is expecting to see 30% year-over-year growth for the segment in the fiscal fourth quarter, a Bloomberg-compiled consensus shows. Investors also want to see a higher contribution to Azure from AI than the 7% figure reported last quarter.

A good performance on those metrics would help Microsoft show its path toward monetizing spending on AI better than some rivals. The software company has had an early lead in releasing generative AI products, with its investment in ChatGPT-owner OpenAI and its fledging Microsoft 365 Copilot — an AI assistant for Office programs — fueling demand for Azure.

“Microsoft has first mover advantage from its investment in OpenAI,” said Zehrid Osmani, a Martin Currie fund manager. “It also has the most natural cross sell opportunity from AI by offering Copilot for $30 per month to its 400 million-plus paying users of Microsoft 365.”

Investors will also be closely watching capital expenditures. Last quarter, Microsoft’s spending was almost $11 billion excluding leases, and management said that capex will rise next year. Demand for AI services is running ahead of the data center capacity Microsoft has available to provide them, requiring an increase in data center outlay.

Daniel Morgan, senior portfolio manager at Synovus Trust, is optimistic that Microsoft will get the balance right between spending on AI and returns from the investments.

“I’m expecting good numbers from Microsoft — they have been pretty forefront in regards to disclosing how much growth is coming from Gen AI, particularly in the Azure datacenter segment, versus how much they’re spending.”

Still, he’s more cautious about the other Big Tech results later in the week.

“When you roll into Amazon and Apple later this week, I don’t know if the Street’s going be satisfied enough that their new AI product roadmap will provide enough return on investment to offset all the capex they are planning on investing.”

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