Why I'm Staying on the Sidelines Headed Into Microsoft's Earnings Report

Shares of Microsoft (NASDAQ: MSFT) have rallied recently, rising about 14% over the last 30 days as of this writing. The move comes ahead of the software and cloud giant's fiscal third-quarter earnings report, which is scheduled for after the market closes on Wednesday, April 29.

A move like this suggests investors are optimistic about the stock headed into its earnings report on Wednesday. But are they right?

While guessing how a stock will move following an earnings report is virtually impossible, we can at least look at the stock's long-term attractiveness heading into the report: Is Microsoft's recent business momentum strong enough to support the valuation investors are paying today?

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Growth remains strong

Microsoft's fiscal second quarter of 2026 (the period ended Dec. 31, 2025) certainly gave investors reasons to remain optimistic about the tech company's potential. Revenue in the period rose 17% year over year to $81.3 billion, and operating income increased 21% to $38.3 billion. And moving down to its bottom line, Microsoft's non-GAAP (adjusted) earnings per share rose an impressive 24% year over year.

Even more, the company's growth was broad-based.

Revenue from Microsoft's productivity and business processes segment, which includes Microsoft 365 Commercial and consumer products and cloud services, LinkedIn, and Dynamics products and cloud services, rose 16% year over year to $34.1 billion. Revenue in intelligent cloud, which includes its cloud computing business Azure, jumped 29% to $32.9 billion. Within this segment, Microsoft's "Azure and other cloud services" revenue rose 39%.

There was one weak spot: revenue in the software giant's "more personal computing" segment, which includes Windows, devices, gaming, search, and news advertising, fell 3% to $14.3 billion. This isn't ideal, but it isn't central to Microsoft's investment thesis today, so it's easy to brush off.

The bigger story is still cloud and AI.

Not only did Microsoft's Azure and other cloud services revenue surge, but the company's pipeline for its cloud business is extremely impressive.

Microsoft's commercial remaining performance obligations (RPO), or contracted commercial revenue that has not yet been recognized, rose 110% year over year to $625 billion, and about 25% of that amount is expected to be recognized as revenue over the next 12 months.

Showing how the company is resonating with customers looking for AI-capable compute, OpenAI accounted for about 45% of the balance.

That backlog is both a sign of strong demand and a reason for caution. While it highlights the company's huge contracted demand, it also captures concentration risk and the need for Microsoft to keep building enough capacity to serve that demand profitably.

Challenges and risks

One problem for Microsoft, however, is that its new growth initiatives -- particularly those that are cloud computing-related -- are capital-intensive. Microsoft's free cash flow was still positive at $5.9 billion in fiscal Q2, but it declined sequentially as capital expenditures rose. Management also guided for Microsoft Cloud gross margin percentage to be roughly 65% in fiscal Q3, down year over year due to continued investments in AI.

Further, competition is everywhere.

In cloud computing, Amazon's (NASDAQ: AMZN) Amazon Web Services (AWS) remains a major cloud computing competitor. AWS sales rose 24% year over year in Amazon's fourth quarter (a significant acceleration from its third-quarter growth rate in the segment), and Amazon CEO Andy Jassy said the company expects to invest about $200 billion in capital expenditures this year. Amazon is also ramping up its custom silicon business, competing with Microsoft's.

Then there's Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL). Google Cloud revenue rose 48% year over year in Alphabet's fourth quarter, and Alphabet said it expects to drop between $175 billion and $185 billion on capital expenditures this year. Alphabet is also pushing its Gemini AI models across search, cloud, and productivity tools -- and not to mention an ambitious custom silicon program.

In short, Microsoft faces well-funded competitors in several important areas at once: AI models, cloud computing, chips, and productivity software. Sure, Alphabet's Google Workspace (the company's productivity suite, including Google Docs, Google Sheets, and more) may not have Microsoft's enterprise footprint, but Alphabet has the distribution, cash, and AI talent to remain a credible long-term threat -- one that may only grow stronger over time.

Is Microsoft stock a buy?

Shares of the software giant currently command a price-to-earnings ratio of about 27. For a company growing revenue in the mid-teens and operating income at a faster rate, that valuation doesn't look expensive at first glance.

But it isn't cheap either.

A lot still has to go right. Microsoft needs to convert its huge backlog into revenue, keep Azure growing at a high rate, absorb rising depreciation from AI infrastructure, and defend Microsoft 365 from a changing software landscape. And no one knows exactly how software economics will evolve as AI agents become more capable.

Ultimately, I think Microsoft's intense competition and big spending to support its growth initiatives make the stock riskier than it looks on the surface -- particularly as it navigates a transitional time in an unpredictable new AI era.

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.