This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
Key Points
-
Microsoft and Nvidia are crushing the S&P 500 so far this year.
-
Microsoft is converting investments into earnings growth.
-
The company continues to find new ways to expand its AI offerings.
On July 9, Nvidia (NASDAQ: NVDA) became the first company to reach $4 trillion in market cap. But Nvidia's stint as the lone company on the $4 trillion podium wouldn't last.
A scorching rally, followed by blowout earnings report and guidance, springboarded Microsoft (NASDAQ: MSFT) above $4 trillion on July 31 -- making these two tech giants the undisputed heavyweight champs in the age of artificial intelligence (AI).
As of market close on July 31, Microsoft was up 26.9% year to date compared to a 7.8% gain in the S&P 500. Microsoft had dropped out of the $4 trillion club by Monday morning, but I'm sure it will get back there. Here are three reasons Microsoft deserves to be in the $4 trillion club and why it could still be a growth stock worth buying now.
1. Entering a new growth gear
Expectations were high for Microsoft's final quarter of fiscal 2025.
Three months ago, the tech giant delivered fantastic results and updated its fiscal 2025 revenue guidance, calling for a 13.8% increase in full-year revenue. Not only did Microsoft surpass that target with 15% full-year revenue growth, but it also boosted margins and earnings.
Microsoft finished the fiscal year with a 45.6% operating margin and a 36.1% profit margin -- meaning it is converting $0.36 of every dollar in revenue into net income.
It's also worth mentioning that Microsoft hasn't been relying on acquisitions to fuel its higher numbers. Rather, it has been expanding its core business segments -- which tends to be a better path to earnings growth because it shows the underlying business is strong and doesn't need to pay for innovation by acquiring talent and ideas.
2. Microsoft is innovating
Growing sales at 15% is impressive on its own for a company the size of Microsoft. But doing so while also expanding margins is a testament to Microsoft's Intelligent Cloud segment, where Microsoft is experiencing high-margin growth fueled by AI.
Azure surpassed $75 billion in fiscal-year revenue as Microsoft continues building more data centers. On the earnings call on July 30, Microsoft said it continues to lead the AI infrastructure wave and now operates more data centers than any other cloud provider.
Microsoft is building larger and more efficient data centers that can handle AI workloads. It is developing tools that are advancing its AI offerings, such as Microsoft Sovereign Cloud for public and private clouds and data and analytics platform Microsoft Fabric, and also pushing forward long-term bets on quantum computing.
Outside cloud services, Microsoft Copilot continues to expand -- surpassing 100 million monthly active users. On the earnings call, Microsoft discussed how some companies initially tried out Copilot and have since expanded their orders to the enterprise level. The rapid adoption reflects the fact that Copilot is becoming an everyday tool for Microsoft 365 users.
Microsoft is unique because it is developing entirely new tools for AI-specific workflows, but it is also upgrading legacy software, like Microsoft 365, to make it more powerful. Innovating while improving core aspects of the existing business has given Microsoft impressive results, and it's why the company is growing revenue and margins quickly despite tough comps.
3. Investments are paying off
Microsoft's earnings growth hasn't come cheap. The company has been pouring resources into research and development, capital expenditures (capex), and operating expenses, and it has seen a surge in stock-based compensation. But Microsoft has been able to make these investments pay off.
Too often, companies will enter a period of expansion, get greedy, and throw resources at ideas that end up being money pits. This position can amplify losses during a downturn. For example, Intel's (NASDAQ: INTC) vertical integration created a more capital-intensive business model. Failing to keep pace with competition that was adopting new semiconductor technology to pack more transistors onto smaller chips led to Intel's falling even further behind.
Ramping up capex on its own isn't good enough. A company must invest in the right ideas and make those ideas benefit the underlying business over the long term, not just result in temporary earnings spikes.
Microsoft is putting on a clinic in capital allocation without neglecting its financial health.
For example, in fiscal 2025, Microsoft finished with $11.9 billion more in cash and cash equivalents on its balance sheet than at the end of fiscal 2024 -- and that's despite growing its expenses and dividend. However, free cash flow grew at 10% compared to 15% growth in operating cash flow as a result of higher capex.
Microsoft is guiding for $30 billion in capex in its current quarter. For context, capex in its latest quarter was $24.2 billion.
In sum, Microsoft has so far been able to convert record spending into record earnings, which is driving its record stock price. But the pace of its capex spending is entering uncharted waters, which will put more pressure on Microsoft to deliver results.
Microsoft's run-up is justified
Wall Street has been rewarding companies delivering AI-driven growth, and Microsoft has been at the forefront of that wave. Microsoft's blowout quarter and guidance suggest that it is pushing even harder on long-term investments -- but it can afford to do so, as evidenced by its rock-solid balance sheet. It continues to grow earnings faster than revenue, meaning that Microsoft isn't compromising efficiency in the pursuit of revenue growth.
Microsoft has done a masterful job allocating capital. Until that changes, Microsoft will likely remain a Wall Street darling. But if it starts showing signs of failing to convert that spending into earnings, it wouldn't surprise me to see the stock sell off.
All told, Microsoft is still worth buying and holding for investors who agree with its aggressive approach to AI and are willing to accept its higher valuation.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
