As the second-quarter report approaches, is Microsoft still making great strides in "AI narrative"?

Last week, Tesla and Google's second-quarter performance disappointed Wall Street one after another, dragging down the Nasdaq. This week, with more tech giants like Microsoft leading the way in releasing their financial reports, Wall Street is holding its breath to see if they can reverse the current unfavorable situation.

Microsoft is scheduled to release its fourth-quarter fiscal year 2024 (second quarter of the 2024 calendar year) earnings after the US market closes on July 30 (early Wednesday morning Beijing time). The current consensus on Wall Street is that Microsoft's second-quarter revenue is expected to increase by 14.5% year-on-year to $64.36 billion (compared to a 17% year-on-year growth in the first quarter), with earnings per share of $2.93, up 8.9% year-on-year.

Barclays believes that, despite high expectations on Wall Street, Microsoft is still expected to deliver a satisfactory second-quarter performance. However, Microsoft's stock price has already risen by 14.7% this year (as of last Friday's close), far exceeding the industry average, so the market may not react significantly to the upcoming financial report.

In a research report released last Friday, Barclays analyst Raimo Lenschow wrote:

We doubt that the fourth-quarter earnings report will be a key factor driving further short-term stock price increases, as the market has already digested these positive signals.

Microsoft's stock price has been steadily rising since the beginning of 2024, reaching a historic high earlier this month. In recent weeks, influenced by recession fears and market rotation, Microsoft has retraced some of its gains. However, overall, Wall Street remains optimistic about Microsoft's prospects, believing that its stock price still has room for further growth supported by AI.

Barclays rates Microsoft as "overweight" with a target price of $475, 11.7% higher than last Friday's closing price.

How Strong is the Azure Business?

The market has high expectations for Microsoft's upcoming financial report and subsequent conference call on Wednesday, especially focusing on its AI product line, including the cloud service Azure and AI assistant Copilot's performance and latest developments.

Barclays believes that Azure is expected to have another impressive quarter, with second-quarter revenue growth expected to exceed the consensus of 30.2%, essentially on par with the first quarter's 31% growth.

However, due to macroeconomic uncertainties and AI capacity constraints, Barclays believes that Azure's growth this quarter may not be as strong as in previous quarters.

Wall Street estimates Azure's second-quarter revenue to be $1.448 billion, a 7.6% increase from the previous quarter, lower than the average 11% growth over the past four years.

By observing network traffic data and the positive performance of GCP (Google Cloud Platform) earlier, Barclays believes that the market demand for cloud services remains strong, which may support Azure to meet or slightly exceed the upper guidance.As for the first quarter of the 2025 fiscal year (third quarter of 2024) and the entire fiscal year, Barclays expects Azure's year-on-year growth rates to be 29% and 28% respectively, with the expected consumption growth of AI services continuing to drive further growth on top of Azure's huge base.

A Microsoft VAR (value-added reseller) survey shows that large transaction activities showed strong seasonality in the second quarter, releasing healthy demand signals, indicating that the market's demand for Microsoft's AI services remains healthy, providing support for Azure's short-term performance.

How Will AI Investments Impact Profit Margins?

Barclays believes that as the 2025 fiscal year approaches, Microsoft will increase its investments in the field of AI, leading to increased costs and potentially putting pressure on profit margins.

During the first quarter conference call, Microsoft management also pointed out that the operating profit margin for the 2025 fiscal year is expected to only decrease by 1 percentage point year-on-year, taking into account the increased AI investments and the impact of the acquisition of Activision Blizzard.

Barclays is confident in Microsoft's ability to achieve this goal, but there are some important factors to consider in the process.

For example, Microsoft's current capital expenditures may lead to depreciation and amortization exceeding market expectations, further causing a slight decline in profit margins for the 2025 fiscal year.

Traditionally, the second quarter has always been the peak of Microsoft's capital expenditures, followed by a continuous decline starting from the third quarter, but this trend was broken last year, and Barclays believes it may be broken again this year.

Barclays expects Microsoft's capital expenditures to grow by 20% year-on-year in the 2025 fiscal year, and then gradually slow down to below 15% in the 2026 fiscal year.