Microsoft Stock Has Been Absolutely Slammed This Year. Is It Finally Time to Buy?
Key Points
The software giant's revenue topped $81 billion in its most recent quarter.
The company's free cash flow recently declined sequentially as it ramped up capital expenditures.
Microsoft's cloud revenue is surging.
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Shares of Microsoft (NASDAQ: MSFT) have been slammed so far in 2026. As of this writing, the stock is down about 19% year to date -- a decline far worse than the S&P 500's 3% pullback.
This sell-off comes even as the company continues to post impressive top- and bottom-line growth.
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So why did shares fall?
The answer likely comes down to the staggering cost of the artificial intelligence (AI) arms race and the risks this race introduces. Even though Microsoft's top line is compounding at an enviable rate, the massive investments required to support this growth are elevating the company's cost structure.
Image source: Microsoft.
Accelerating AI demand
Microsoft's second-quarter results for fiscal 2026 showed a business firing on all cylinders.
Total revenue in the period came in at $81.3 billion. And the company's profitability was particularly impressive. Microsoft's non-GAAP (adjusted) net income jumped 23% year over year to $30.9 billion.
Highlighting the software giant's underlying momentum, its Microsoft Cloud segment was a key driver for the business.
"Microsoft Cloud surpassed $50 billion in revenue for the first time, up 26% year-over-year, reflecting the strength of our platform and accelerating demand," Microsoft CEO Satya Nadella explained in the company's second-quarter earnings call.
The company is seeing rapid adoption of its AI-powered software tools, too. Microsoft 365 Copilot -- the company's generative AI -- saw paid seats hit 15 million during the quarter. This was up more than 160% year over year. In addition, paid subscribers for GitHub Copilot reached 4.7 million, climbing 75% year over year.
And Microsoft's overall business momentum should continue. Management guided for third-quarter fiscal 2026 revenue of $80.65 billion to $81.75 billion. The midpoint of this range implies a strong year-over-year growth rate of about 16%.
The high cost of AI
But looking under the hood, things become more concerning.
The AI build-out is incredibly expensive.
While the company is generating massive amounts of cash from its operations, its free cash flow, or its cash flow from operations less capital expenditures, came in at just $5.9 billion in the second quarter. This represented a notable sequential decline as the company's heavy infrastructure spending offset its robust operating cash flow.
Even worse, these mounting costs are beginning to pressure the company's profit profile.
"Company gross margin percentage was 68%, down slightly year-over-year primarily driven by continued investments in AI infrastructure and growing AI product usage," Microsoft chief financial officer Amy Hood emphasized during the company's earnings call.
In other words, while AI is driving top-line growth, it is also highly capital-intensive. And it's arguably necessary to stay relevant as other tech giants are ramping up their own capital expenditures on AI. As these infrastructure investments continue to rise, they'll increasingly show up as depreciation, creating a headwind for Microsoft's earnings.
Is it time to buy?
With Microsoft down sharply this year, investors might be tempted to view this as a buying opportunity.
But I don't think it is.
Of course, it is possible that the company's massive investments yield an incredible return over the next decade. But I'm not convinced the stock is a safe bet today.
As of this writing, Microsoft trades at a price-to-earnings ratio of about 25. A valuation like this assumes the company will successfully thwart any threats to its business in an AI-first era, protecting its competitive advantages and continuing to grow revenue and earnings rapidly.
And if the AI infrastructure build-out takes longer to pay off, or if competitive pressures force the company to keep capital investments elevated for years to come, the company's earnings growth could slow, and the stock's valuation multiple could even contract.
Overall, I believe Microsoft simply doesn't offer enough of a margin of safety right now. I'd avoid shares and wait for a potentially bigger discount before adding this tech giant to my portfolio.
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Daniel Sparks and his clients have no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Microsoft. The Motley Fool has a disclosure policy.
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