Is Microsoft’s AI CapEx creating a telecom-style capital-intensity risk?

I read Microsoft’s latest report and kept asking myself, what does this remind me of? And at one point... oh my God, bingo... it’s Verizon.

I was looking at the comparison between Free Cash Flow & Owner Earnings and CapEx vs D&A.

And I realized that Microsoft is now partially in the same situation Verizon was in a few years ago. What do I mean? Here’s what.

Think about how mobile communications developed. It all started with NMT (maybe there was something before that, but that’s where I remember it starting), then GSM appeared, followed by 3G, 4G, and now 5G. Every new standard required huge capital investments in the network. And Verizon, as one of the market leaders, spent a ton of money building its 4G and 5G networks.

And of course, they’re now generating revenue thanks to those investments. Judging by the reports, over the last two years they’ve been investing in the network at roughly the level of depreciation. In other words, the major construction phase is behind them, but CapEx hasn’t gone away.

And this is where I draw a parallel that could be called an arms race.

Microsoft is now spending huge amounts of money building infrastructure for artificial intelligence. And of course, the market demands it. But just like mobile communications standards, AI chips require constant investment because they become obsolete quickly.

Someone might say, so what? They’ll still generate revenue from those investments in the end. Yes, but here’s the problem: those investments might not create a strong enough economic moat or give Microsoft enough pricing power.

Look at Verizon. The money has been spent on infrastructure, but can Verizon simply raise the prices of its services? No, because competition doesn’t allow it. And they can’t really lock customers in, because a customer can just switch to another carrier without changing their phone number.

Microsoft is obviously different. It has Azure, Microsoft 365, enterprise customers, and an ecosystem of products. So I’m not saying Microsoft is the second Verizon.

But the problem could be similar. If AI infrastructure becomes a capital-intensive and competitive service, and those huge investments don’t provide enough pricing power or return on invested capital, then this whole race might not turn out to be so great for shareholders.

As I see it, all of this could lead Microsoft to accumulate a huge amount of debt. No, I’m not saying they won’t be able to service it. Microsoft currently has very strong operating cash flow. But if CapEx continues to grow faster than operating cash flow, Microsoft will either have to spend less on dividends, buybacks, and other things, or it will have to borrow more. And then debt service will take a larger share of its profits.

This thought is also driven by the Gross, Operating, and Net Margin figures.

Over the last year, Microsoft’s Gross Margin was 67.9%, Operating Margin was 46.9%, and Net Margin was 40.3%. Meanwhile, Verizon’s Gross Margin was 58.9%, Operating Margin was 21.2%, and Net Margin was 12.4%.

What interests me about these numbers is that the gap between Microsoft’s Operating Margin and Net Margin still doesn’t look very large, while at Verizon it’s much larger (I mean the relationship, not the absolute figures). If Microsoft has to increase its debt substantially, this gap could start to widen because of interest expense.

And that’s exactly what makes me think Microsoft could eventually face a situation where it has to service more debt and its net margin starts to decline. This isn’t a prediction or a claim that it will definitely happen. But it’s definitely something worth watching.

I’m not going to predict how the market will react to this, but I think it wouldn’t be good for shareholders either way.