Microsoft Corp will be the first of the big techs after Netflix to report its latest quarterly results on Tuesday, January 24 after the market close. The company has seen its earnings growth dwindle over the past year, partly as the post-pandemic boom fades and partly due to the Fed-induced slowdown in the economy. But the Seattle-based firm has big plans for the future, specifically when it comes to Artificial Intelligence (AI). Will investors be impressed enough to start buying the stock again?

From boom to bust

Not immune to the tech selloff and the broader bear market on Wall Street, Microsoft’s share price slumped by about 28% in 2022 and is down 31% from its all-time high of $349.67 reached in November 2021. Although the stock has recovered by more than 10% from the October trough when it brushed a near two-year low, it has a long way to go before reversing its year-long downtrend.

The pandemic-era tech darlings have been underperforming the wider market for much of 2022, though Microsoft, along with Apple, have fared somewhat better. Microsoft’s success in the cloud computing arena and the growth prospects of its own Azure platform have given the stock an edge over its rivals.

Is Microsoft’s growth engine in trouble?

The cloud business will once again be the primary focus for the firm’s fiscal second quarter results. Last time, the company sparked concern that the days of astronomical growth in the cloud unit are coming to an end after missing its own guidance for the second consecutive quarter and lowering it for the next. With investors already anxious about Azure’s decelerating revenue growth, CEO Satya Nadella fuelled more concern in a recent interview by warning that the next couple of years will be tough for the tech sector.

However, few doubt that the cloud business still has massive growth potential and the main risks in the medium-term are the question marks around the severity of the current downturn in the US and global economy and the extent to which Microsoft’s revenue will be hit by it. The economic slowdown is also expected to hurt subscription revenue for its Office product suite as well as sales of its Windows operating system amid declining PC shipments of both its own product range and of other manufacturers.

On the verge of an earnings recession

According to estimates by Refinitiv IBES, the company is expected to report revenue of $52.93 billion for the quarter ending in December, which would represent a 2.3% year-on-year increase – the slowest since 2017. Earnings per share (EPS) are forecast to drop, however, by 7.7% from the same quarter a year ago to $2.29, marking the first annual decrease since 2015.

A bounce higher cannot be ruled out

Heading into the earnings announcement, the likelihood of a big positive surprise isn’t looking very high. But this does mean that should the company substantially beat the estimates, the stock price could jump and aim for the December 2022 peak of $263.92, although this would involve overcoming the 200-day moving average at $257.

However, if the earnings disappoint, Microsoft shares could plummet back towards the $215 area that contains the October low and the 61.8% Fibonacci retracement level of the post-pandemic rally. Holding onto this support region is key for the stock’s ability to reverse its fortunes in the short-to-medium term and not deepen its bearish formation.

Betting big on AI

But much of how the stock price reacts will also depend on the company’s guidance for the current quarter and any comments about the outlook for the rest of 2023. There’s a danger that investors have still not fully priced in the impact of an earnings recession, not just for Microsoft but for all of Wall Street. The company just announced job cuts of up to 10,000, in a sign that it expects things to get worse before they get better. If the guidance adds to the pessimism for the earnings outlook, it could magnify any selling pressure.

Investors will also want to hear more about Microsoft’s future plans and in particular, how it intends to develop and integrate the use of AI in its platforms such as its Azure cloud services and Bing search engine. If the company is able to generate enough excitement for its reported $10 billion investment in OpenAI – the firm behind the recently launched AI platform ChatGPT that has taken the internet by storm – it might just be able to offset any gloom from its financial results.

Activision deal hits stumbling block

An investment that’s not going so smoothly, however, is the acquisition of gaming giant Activision Blizzard. The deal is receiving intense scrutiny from regulators, both in America and in Europe, and if blocked, it could scupper the firm’s gaming ambitions. However, with investors not overly enthusiastic about the tie-up, the stock could gain if the merger were to be called off.

The growing clouds gathering over Microsoft have led some analysts to downgrade the stock to either hold or sell, although for now, the majority are maintaining their buy recommendation. The median target also keeps getting downgraded and currently stands at $285, which is a premium over the current market price of about $235.

Still high valuation

From a valuation perspective, Microsoft remains expensive and its trailing price/earnings (PE) ratio is only beaten by Amazon among its biggest rivals. Even its 12-month forward multiple is somewhat higher than the likes of Apple and Alphabet, though it is on par with the average of other tech firms in the Nasdaq.

The main challenge for Microsoft going forward will be justifying its existing valuation in a deteriorating macroeconomic environment. Yes, the stock is still attractive in terms of dividend payouts and being one of the least risky of the big tech clan. It’s also worth noting that its PE ratio is below its historical average despite not stacking up too well against its peers’. But when considering that the Fed has yet to complete its rate-hike cycle and the persisting dangers of overtightening and a recession, the share price may yet scale new lows as it could be several more quarters before earnings growth can pick up again.