Microsoft Corporation (NASDAQ:MSFT) has long been treated as the safer way to own cloud computing, supported by its corporate subscriptions, large customers, and an established profit stream. Alphabet Inc. (NASDAQ:GOOGL) is beginning to complicate that argument.
Google Cloud is expanding much faster than Azure, and, crucially, the additional sales are producing substantial operating profit. Yet Yahoo Finance’s latest valuation data shows that Microsoft is trading at 25.13 times forward earnings against 22.83 times for Alphabet. The gap is modest, but the question behind it is considerable. Does Microsoft’s predictable software business still warrant a premium when Google’s cloud economics are improving so rapidly?
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Bull Case
Alphabet’s latest figures deserve more attention than its spectacular headline EPS. Second-quarter Google Cloud revenue jumped 82% to $24.8 billion, while operating income rose from $2.8 billion to $8.8 billion. This marks meaningful progress toward turning infrastructure demand into profits for the company. In other news, an ex-Google researcher said AI could “Kill Us All”. Should Alphabet investors care? Read here.
Meanwhile, Google Search and related advertising revenue increased 17% to $63.3 billion. Search is still funding much of Alphabet’s expansion, but Cloud is becoming a much more substantial contributor. The combination helps explain why consolidated operating income grew 30% on revenue growth of 24%. Alphabet does not need every new AI service to become an immediate standalone business for its existing operations to benefit. In addition to GOOG, the financial media is also favoring other big name stocks. Find here.
Microsoft’s advantage is the breadth of its customer relationships. Azure and other cloud services revenue grew 43% in its June quarter, while Microsoft 365 Commercial cloud continued expanding. Its Productivity and Business Processes division earned $21.9 billion in operating income, providing a profitable counterpart to the more capital-intensive cloud infrastructure business. Across the company, Microsoft earned $40.6 billion in operating income on $90.0 billion of revenue. We also shortlisted the best healthcare stocks to buy according to hedge funds. Check out the complete list here to make an informed decision.
Bear Case
Neither company’s cloud growth is free. Microsoft Corporation (NASDAQ:MSFT) spent $35.8 billion in cash on property and equipment during the quarter, more than double the prior-year amount. Its cloud gross margin slipped to 65%, which management attributed partly to the growing mix of Azure revenue and AI infrastructure investments. Microsoft can absorb those costs today, but the direction challenges any assumption that additional cloud revenue automatically brings higher margins. Read more about what Michael Burry has to say about MSFT stock here.
Alphabet’s spending is even harder to ignore. Purchases of property and equipment reached $44.9 billion against $39.1 billion of net cash provided by operating activities, leaving approximately negative $5.85 billion in quarterly free cash flow. That does not negate Cloud’s improving operating profitability, but it does show how far accounting profits and cash generation can diverge during an infrastructure buildout.
Alphabet’s reported $9.11 quarterly EPS, reflecting 294% growth, is also an unreliable measure of recurring improvement, as the company recorded roughly $98 billion in net other income, largely from net unrealized investment gains on its equity securities. Its 30% operating-income growth is the more defensible figure for evaluating underlying performance.
Conclusion
Alphabet Inc.’s (NASDAQ:GOOGL) lower forward multiple is intriguing because Cloud now contributes profits at a scale that would have seemed unlikely only a few years ago. Microsoft Corporation (NASDAQ:MSFT), though, retains a more diversified enterprise earnings base and substantially higher consolidated operating margins.
The deciding issue is less whether AI demand persists than whether either company can keep turning it into cash after paying for the infrastructure required to serve it. Google’s improving cloud margins narrow the argument for Microsoft’s valuation premium, and its cash spending prevents that argument from disappearing entirely.
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This article is originally published at Insider Monkey.
