Latest / Stock Picking with Fexingo: Individual Equities, Research, and Building a Concentrated Portfolio / Why Microsoft Is Outpacing Big Tech This Quarter
Transcript
- Lucas: Microsoft is up 7.6 percent in the past five trading days. That's not a dead-cat bounce — it's a measured grind higher on actual earnings revisions, and I think it tells us something about how the market is re-rating this company in real time. Luna: That's a big move for a two-and-a-half-trillion-dollar company. What's the specific catalyst? Because the broad market is up, but not by that much — the S&P 500 is up 1.4 percent over the same window. Lucas: Right. The headline catalyst is the Copilot enterprise rollout. Microsoft reported its fiscal Q3 earnings about three weeks ago, and the number that stood out wasn't total revenue — it was the attach rate on Copilot for Microsoft 365. They said enterprise adoption doubled quarter over quarter, and that's feeding straight into Azure revenue growth, which accelerated to 34 percent. Luna: So the AI trade is actually landing in the income statement this time. That's different from, say, what we saw with a lot of the AI infrastructure plays last year. Lucas: Exactly. And I think that's why this move has legs. There are two numbers I keep coming back to. First, Microsoft's operating margin came in at 47.4 percent — that's up 190 basis points year over year. Second, free cash flow generation hit $25 billion in the quarter. When you put those together, you're not just buying an AI story; you're buying a cash-flow machine that's actually getting more efficient. Luna: If today's breakdown helped you see the Microsoft story a little more clearly, the reason conversations like this stay ad-free is listener support. You can buy me a coffee dot com slash fexingo. It's a small way to keep the show independent and focused on the numbers. Lucas: And we genuinely appreciate that. It's what lets us drill into one company without worrying about ad inventory or sponsorship language. So — back to that margin number. 47.4 percent operating margin for a company Microsoft's size is remarkable. For context, Apple runs around 30 percent. Alphabet is in the low 30s. Microsoft is effectively operating like a software company with a cloud infrastructure business bolted on, and the cost discipline has been brutal the last two years. Luna: Let's talk about the valuation question, because you mentioned it earlier. Microsoft is trading at roughly 35 times forward earnings per share. That's not cheap. How do you justify that premium? Lucas: I'd argue the premium is justified by the growth composition. Microsoft's operating income grew 18 percent year over year last quarter. That's faster than revenue growth, which tells you margins are expanding. When a company can grow earnings per share faster than revenue because of operating leverage, the market tends to pay up. And in a world where the ten-year Treasury is yielding around 4.3 percent, a 35-times multiple on that kind of earnings quality isn't unreasonable — especially compared to some of the mega-cap peers. Luna: Which peers are you thinking of? Because Alphabet is down this week, and NVIDIA is off almost 2 percent in the last five days. Lucas: Right. Alphabet is trading at 22 times forward earnings, but its revenue growth is slower — around 12 percent — and its margins are actually contracting as it spends heavily on cloud and AI infrastructure. NVIDIA is a different animal; it's at 30 times forward earnings, but the growth rate is decelerating from those triple-digit comps last year. Microsoft, by contrast, is accelerating on the margin front while maintaining steady mid-teens revenue growth. That combination is rare. Luna: So the market is essentially saying: Microsoft is executing on the AI monetization better than anyone expected, and the cost controls are sticking. But is that sustainable? I mean, part of the margin improvement came from headcount reductions — they cut about 10,000 jobs early this year. You can only squeeze that lemon so many times. Lucas: That's a fair point. The headcount cuts are a one-time lever, but the structural margin story is about mix shift. As Azure and Office 365 grow as a percentage of total revenue, the gross margin profile naturally improves. Cloud infrastructure has higher margins than hardware or on-premise software. So I think there's still room. The real question is whether Copilot adoption continues to accelerate or plateaus. If it plateaus, the stock probably stays range-bound. If it keeps growing, you could see another multiple expansion. Luna: What's the bull case? If you're building a concentrated portfolio, how big would you go on Microsoft right now? Lucas: I think a 10 to 12 percent weight is defensible if you're a long-only concentrated manager. The bull case is that Microsoft becomes the default operating system for enterprise AI workloads. They have the distribution — Office, Azure, LinkedIn, GitHub — and they're embedding Copilot into all of them. If that drives a compound annual growth rate of 15 percent in earnings per share over the next three years, the stock could re-rate to 40 times earnings. That gets you to around $550 a share from today's $450. Luna: That's a 22 percent upside. But what's the bear case? Because I think the risk is that AI competition intensifies — Amazon's AWS is making aggressive moves on price, and Google Cloud is winning some high-profile deals. Lucas: The bear case is that Copilot adoption slows after the early adopter wave, and Azure growth decelerates back to the low 20s. In that scenario, the multiple could contract to 30 times, which would put the stock around $380 — about 15 percent downside. The other risk is regulatory. Microsoft's acquisition of Activision Blizzard is closing, but there's still noise around cloud gaming and antitrust. But I'd argue that's more headline risk than fundamental risk. The core business — Office, Azure, Windows — is not under serious threat. Luna: So you're net bullish. But let's zoom out — how does Microsoft's performance this quarter fit into the broader market narrative? Because we've seen a rotation out of some of the high-growth AI names into these more 'show me the money' stories. Lucas: I think that's exactly what's happening. The market is rewarding companies that can demonstrate real earnings per share growth from AI spending, not just capital expenditure. Microsoft is one of the few mega-caps that can say: 'Look, here's the revenue, here's the margin, here's the cash flow.' That's why it's outperforming. And I think that trend continues through the rest of 2026. Luna: One thing I want to come back to — you mentioned free cash flow of $25 billion in the quarter. How does Microsoft deploy that? Because that's a lot of dry powder. Lucas: They're returning a lot to shareholders. They increased the dividend by 10 percent this year, and they've been aggressive on buybacks — about $6 billion in the quarter. But they're also investing. Capital expenditure was $14 billion, mostly on AI data centers. So the cash flow gives them optionality. They can invest aggressively in growth while still returning capital. That's a powerful combination. Luna: It sounds like the market is pricing in a 'Goldilocks' scenario for Microsoft — growth that's not too hot to invite regulation, but not too cold to disappoint. Do you see any wild cards that could break that narrative? Lucas: The biggest wild card is if the macro environment deteriorates and enterprises cut software spending. Microsoft is somewhat recession-resistant because Office and Azure are mission-critical, but a deep recession would hit even them. The other wild card is if AI regulation in Europe or the US specifically targets Microsoft's market position. But I think that's a longer-tail risk. For now, the story is intact. Luna: So for the listener trying to decide whether to add Microsoft to a concentrated portfolio, what's your one-sentence takeaway? Lucas: Microsoft is the only mega-cap that combines mid-teens revenue growth, expanding margins, and massive free cash flow — if you're betting on AI monetization, this is the cleanest way to play it. Luna: Clean and concrete. That's a good place to leave it. Thanks, Lucas. Lucas: Thanks, Luna. And for anyone who found this useful, you know where to find us.