Will Microsoft Ultimately Be an AI Beneficiary or Be Hurt by It?

At first glance, it is easy to assume that Microsoft (NASDAQ: MSFT) is a clear beneficiary of artificial intelligence (AI). Not only does it have an investment in OpenAI, the parent company of ChatGPT, but the software giant's early moves placed it at the center of the generative AI revolution, driving rapid adoption of its tools and infrastructure.

The company's fiscal Q2 results, reported in late January, seemingly confirmed this optimistic narrative. Revenue climbed 17% year over year to $81.3 billion, and its non-GAAP (adjusted) earnings per share rose 24% to $4.14. Even more impressively, the company's commercial remaining performance obligations (RPOs) -- a metric that captures commercial contracts yet to be recognized as revenue -- skyrocketed 110% to a staggering $625 billion.

But there are also some serious concerns for Microsoft shareholders to ponder. Look under the hood, and the financial reality of this AI transition looks much more complicated.

Image source: Getty Images.

A concentrated backlog and margin pressure

Let's start with that massive backlog. While 110% growth looks exceptional on the surface, OpenAI represents 45% of Microsoft's massive backlog. That translates to about $280 billion in future commercial commitments tied to a single partner. This, however, is just as much a concern as a tailwind. If you strip out this specific customer, the rest of the commercial backlog grew at a much slower 28% rate -- hardly ahead of Amazon's (NASDAQ: AMZN) accelerating growth rate in cloud computing revenue and well behind Alphabet's (NASDAQ: GOOG)(NASDAQ: GOOGL).

Furthermore, Microsoft's massive investments in AI are starting to weigh on its profitability. In fiscal Q2, the company's capital expenditures hit $37.5 billion, representing a significant jump from $22.6 billion in the year-ago quarter. This heavy spending to acquire graphics processing units (GPUs) and build out data centers is already pressuring margins.

Indeed, the company's gross margin actually narrowed year over year to 68%. And the pressure is expected to persist. In addition, the company guided for its operating margin in fiscal Q3 to be down year over year.

"Gross margin percentage was 68%, down slightly year over year, primarily driven by continued investments in AI infrastructure and growing AI product usage," explained Microsoft chief financial officer Amy Hood during the company's fiscal Q2 earnings call, noting that these infrastructure costs outpaced efficiency gains. By how much, exactly, did Microsoft's gross margin narrow? It was 68.7% in the year-ago quarter.

Intense competition and massive capital requirements

Adding to the challenge, competition is extremely heated. Amazon is already the leader in cloud computing, and it has recently reaccelerated its growth. Amazon Web Services (AWS) revenue rose 24% year over year to $35.6 billion in its most recently reported quarter. This marked a clear step up from the 20% growth it posted in the prior quarter.

Meanwhile, Microsoft's cloud computing business, Azure, failed to reaccelerate in fiscal Q2. Microsoft's cloud computing business saw revenue grow 38% on a constant-currency basis, a slight deceleration from 39% in the prior quarter.

And Alphabet's cloud computing business is putting Azure to shame. Google Cloud revenue soared 48% year over year in Q4.

Amazon clearly isn't resting on its laurels, and Google parent Alphabet isn't either.

Nowhere is the intense level of competition in the space clearer than in companies' capital expenditure budgets. Amazon and Alphabet have enormous spending budgets dedicated largely to capturing AI workloads. Amazon's management recently indicated it expects to invest about $200 billion in capital expenditures in 2026. Alphabet is also forecasting a massive step-up in spending, with expected capital expenditures for 2026 to be between $175 billion and $185 billion.

Overall, this may be a period of intense competition in which Microsoft's profit margins narrow significantly over the next five years, more than offsetting any accelerated top-line momentum due to the AI boom. The sheer cost of competing in the AI infrastructure space means that the hyperscalers are essentially engaged in an arms race, increasing risks, creating more uncertainty, and weighing on returns on invested capital.

Is the stock a buy?

With Microsoft trading at a price-to-earnings ratio of about 23 after taking a significant year-to-date beating, investors seem to be doing a better job than they were at the start of the year of pricing in the increasing uncertainty in the space. Still, given how ferociously Amazon and Alphabet are fighting for the same cloud-computing pie, I wouldn't buy the stock at this level.

Ultimately, I think investors should tread carefully with Microsoft stock right now. The company is undoubtedly an exceptional business, but the market's current valuation leaves very little room for error if the returns on its massive AI investments take longer to materialize than Wall Street expects.

Daniel Sparks and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, and Microsoft. The Motley Fool has a disclosure policy.