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Microsoft (NASDAQ: MSFT) has rallied from its 2026 lows in a similar fashion to its "Magnificent Seven" peers, Nvidia, Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL), Apple, Amazon (NASDAQ: AMZN), Meta Platforms, and Tesla. But even with that recovery, Microsoft is still down 15.7% year to date -- a significant underperformance relative to both the S&P 500 and Nasdaq Composite.
Here's why Microsoft's investment thesis has gotten more complicated, and how to approach this stock right now.
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Microsoft reported excellent quarterly results on April 29. For its fiscal 2026 third quarter, which ended March 31, it grew revenue by 18% year over year, operating income by 20%, non-GAAP (generally accepted accounting principles) net income by 20%, and non-GAAP diluted earnings per share by 21%. Microsoft's artificial intelligence (AI) revenue surpassed an annual run rate of $37 billion, a 123% increase. Azure and other cloud services grew revenue by 40%.
On the earnings call, Microsoft said it expects its capital expenditures to exceed $40 billion in the fourth quarter of its fiscal 2026. But for calendar 2026, Microsoft expects $190 billion in capex. This means that Microsoft plans to spend around $118 billion on capex in the second half of calendar 2026 (the first and second quarters of fiscal 2027).
For context, in its fiscal 2025, Microsoft laid out capital expenditures of $64.5 billion. So its quarterly capex budget will soon be roughly what its annual capex was less than two years ago. That drastic change in its capital allocation strategy is a reason for even the most confident long-term Microsoft investors to ask themselves whether this level of spending will be worth it, and whether the money is being used effectively.
Microsoft's spending isn't even at peak levels, and it's already taking a sledgehammer to its profitability and free cash flow (FCF). In its latest quarter, Microsoft reported $15.8 billion in FCF, which was still plenty to cover $10.2 billion in dividends and share repurchases. But it was a 22.2% year-over-year decrease.
In Microsoft's defense, part of the reason for the heightened spending is that it is in a full-throttle race with other hyperscalers for AI chips and networking equipment to build data centers. But supply-chain constraints have created an AI bottleneck -- pressuring Microsoft into bidding wars for hardware with its peers. Amazon, for example, plans to spend $200 billion on capex in 2026. On its April 29 earnings call, Microsoft said that two-thirds of its $31.9 billion in quarterly capex went toward graphics processing units (GPUs) and central processing units (CPUs).
Despite higher operating expenses, Microsoft expects its operating margins to increase by 1 percentage point year over year, thanks to high-margin growth in key segments like cloud computing. Microsoft's operating margin hit a 20-year high of 45.6% in fiscal 2025.
In the third quarter of its fiscal 2026, Microsoft's commercial bookings decreased by a staggering 46% on a constant-currency basis due to lower commitments from OpenAI. Microsoft remains OpenAI's primary cloud partner, but recent changes to the agreement between the two mean that OpenAI can now use other cloud providers. In fact, Amazon published a press release on April 28 stating an expanded partnership that brings the latest OpenAI models to Amazon Web Services (AWS).
On Microsoft's second-quarter fiscal 2026 earnings call in late January, the company was criticized for being heavily dependent on OpenAI, as 45% of its $625 billion in remaining performance obligations were tied to it. When ChatGPT was considered the leading large language model (LLM), that concentration wouldn't have been seen as a bad thing. But advancements by Alphabet's Google Gemini and Anthropic's Claude LLM are pressuring ChatGPT, especially given that Microsoft's Copilot is powered by ChatGPT.
Microsoft's latest quarter demonstrated how changes to the OpenAI agreement could work in its favor. The revised agreement gives Microsoft royalty-free access to OpenAI's intellectual property through 2032 and sustained revenue sharing through 2030, in addition to its equity stake. Copilot produced far better results, with Microsoft 365 Copilot paid seats increasing by 250% year over year, the fastest growth since Microsoft launched the service in the fall of 2023.
GitHub Copilot enterprise adoption tripled year over year, and usage of GitHub Copilot's command-line interface, a live AI agent for developers, nearly doubled month over month in the period.
Microsoft is a mess because it has transformed from a relatively capital-light, high-margin cash cow business model into a capital-intensive hyperscaler in just a few years. What's more, OpenAI no longer has the undisputed leading LLM, and Microsoft's relationship with it has changed drastically. But at the same time, Copilot's results have been excellent, Microsoft is growing at a far faster pace than in recent years, and it's generating all-time-high profits and high margins.
To make the investment thesis even more complicated, Microsoft hasn't been nearly as successful as Alphabet or Amazon at developing and implementing custom AI chips at scale. Both Google Cloud and AWS are achieving massive cost and efficiency gains thanks to their custom chips. On its April 29 earnings call, Alphabet said it will begin selling its custom chips to a select group of customers that own data centers. Amazon said that its custom chip business has a $20 billion annual revenue run rate, but would be worth $50 billion if it sold chips to third parties.
Microsoft is out of favor because its AI spending profile isn't as lean as its peers. Investors also expect margins and profitability to come down, and its relationship with OpenAI simply isn't as much of a competitive advantage as it was a couple of years ago. However, Microsoft still has an impeccable balance sheet, pays a growing dividend with the highest yield among the Magnificent Seven (0.9% at the current share price), and trades at just 24.4 times forward earnings. Alphabet and Amazon have forward price-to-earnings ratios over 34.
All told, Microsoft is an excellent value for investors who believe its AI spending will pay off in the long run and that its new agreement with OpenAI will unlock additional value and flexibility. However, Microsoft has more question marks than the other cloud giants, so it's understandable that its stock is in the bargain bin today.
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Daniel Foelber has positions in Nvidia. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla. The Motley Fool has a disclosure policy.
Microsoft Is a Mess. Is the "Magnificent Seven" Stock a Buy in May or Better Avoided? was originally published by The Motley Fool