Microsoft: A Cautionary Tale Of Chasing Hype Without Considering Risks

Summary:

• Microsoft stock has underperformed the S&P 500 since my previous caution in late April. Recent buyers who attempted to chase the AI hype were given a reality check.
• MSFT has an “F” valuation grade, the worst possible in Seeking Alpha’s Quant toolbox. Astute sellers who got out at its mid-July highs correctly anticipated the selloff.
• Despite that, Microsoft’s AI opportunities are still in the earlier stages. Therefore, cutting all exposure doesn’t make sense, even though MSFT is expensive.
• Investors are reminded to hold through the ups and downs of MSFT as it ramps up CapEx to drive market leadership and gain more share.
• I make the case for why MSFT remains a Hold. I also elaborate on the levels investors must watch carefully for buying opportunities. Read on.

Microsoft’s (NASDAQ:MSFT) stock has slightly underperformed the S&P 500 (SPX) since my previous update (Hold rating) in late April 2023. Late buyers chased it toward its July high of about $367 before sellers forced a decisive selloff. As such, MSFT has retraced more than 10% toward yesterday’s (August 2) close.

MSFT has lost upward momentum despite posting a pretty robust fourth-quarter earnings release for FY23 or FQ4. The financial media referred to Microsoft’s tepid FQ1 guidance as the main reason for the selloff. However, a closer inspection of MSFT’s buying sentiments suggests that sellers had already anticipated it, as it topped out in mid-July, before its earnings release.

Despite that, Microsoft management remains confident that the company is still in the early stages of the generative AI gold rush as it ramps up capital expenditures or CapEx to gain share against its hyperscaler rivals.

CEO Satya Nadella also referred to a total addressable market or TAM expansion, even though AI monetization is expected to remain gradual. Therefore, I assessed that the recent pullback is welcome to knock some much-needed reality into momentum buyers chasing its previous breakout.

Notwithstanding the weak near-term sentiment, Microsoft expects a significant increase in CapEx is necessary to ensure that it’s well-positioned to leverage AI revenue opportunities. CFO Amy Hood accentuated that the “CapEx acceleration is broad, encompassing both data centers and physical equipment like CPUs, GPUs, and networking equipment.”

Data center supply chain sources indicate they “are gearing up to ship AI servers in the second half of 2023, expecting them to drive profit growth in the server industry.” These are costly pieces of equipment, with the data center supply chain indicating that “the average unit price of AI servers is three times higher than that of general-purpose servers due to the expensive Nvidia (NVDA) chips used in AI servers.”

Moreover, Microsoft also sees the possible completion of the post-pandemic Azure optimization phase. Therefore, management’s commentary suggests that the ongoing cloud migration is expected to reaccelerate; as Hood articulated, “the increase in CapEx is driven by the growing demand for both normal Azure workloads and AI workloads.”

With that in mind, investors who expected a sharp upward inflection of Microsoft’s operating profitability and margins were likely disappointed. It’s clear that Microsoft needs time to monetize its AI opportunities, and the inflection is expected to be more gradual than what MSFT’s expensive valuation suggested.

MSFT has an “F’ valuation grade by Seeking Alpha’s Quant, suggesting that investors likely need more convincing about its near-term underlying AI growth drivers. Despite boasting a peer-leading profitability grade of “A+,” dip buyers who bought MSFT from late last year to early this year likely used the recent opportunity to cut exposure and rebalance their portfolio.

I’ve also trimmed my MSFT positions at a higher price level, bringing my total exposure back to my desired levels, previously indicated to members of my service.

However, with MSFT well-positioned to leverage medium-term AI opportunities, I don’t see an immediate or pressing need to cut all exposure. I’m ready to hold on to MSFT and endure the ups and downs.

However, I urge investors considering adding MSFT now to be patient, as it needs to resolve the bull trap (false upside breakout) in mid-July. We must assess and observe dip buyers returning constructively and confidently to defend against its recent pullback.

I assessed a few possible levels that investors are urged to consider. MSFT buyers could reappear at the low $300s level. Failing which, the mid-$280s level is also another opportunity to consider robust buying support. A steeper fall toward the low $270s level is unlikely for now but can be regarded as a high-conviction buy zone if it gets there.

However, assessing how MSFT’s price action could pan out is still too early. As such, I maintain my thesis to wait for more clarity from positive buying sentiment before adding more exposure.

Rating: Maintain Hold.

Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of MSFT, NVDA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha’s Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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