Microsoft’s giant AI bet will lead to more than $100 billion in data center leases

AS Microsoft As investors prepare for quarterly earnings this month, there’s one particular metric that has become increasingly important: finance leases.

A finance lease allows a company to pay for an asset over the years, rather than up front. For companies like Microsoft that are building massive data centers to handle AI workloads, shareholders need to get used to big numbers.

In July, Microsoft told investors in a footnote to its annual report that outstanding finance leases had risen to $108.4 billion, up $20.6 billion from the previous quarter and almost 100 billion dollars more than two years earlier. The leases will begin between fiscal years 2025 and 2030 and last up to 20 years, the document states.

Overall, Microsoft made $19 billion in capital expenditures last quarter. The total, which includes assets acquired through finance leasing, increased from $14 billion in the March quarter and was equal to what Microsoft shelled out in the entire 2020 fiscal year.

“It’s a crazy ramp,” said Charles Fitzgerald, a former Microsoft executive who writes about capital spending on his Platformonomics blog.

Investors will have further clarity on Microsoft’s lease financing when the company reports fiscal first-quarter results in late October. Executives at Microsoft and other major technology companies have approved increased capital spending over the past two years, often to improve their performance in generative artificial intelligence.

Last month, Microsoft confirmed its participation in a fund to support the development of necessary data centers and energy infrastructure, mainly in the United States. It also signed a 20-year power purchase agreement to restart a reactor at the Three Mile Island nuclear power plant in Pennsylvania.

Microsoft’s higher costs in the June quarter were no surprise to those who followed finance chief Amy Hood’s guidance in April. He said for the third time in a year that Microsoft expects capital spending to grow “materially.”

However, RBC Capital Markets’ Rishi Jaluria was taken aback by the lease-back figure.

“I’m always on the side that capital rents and capital expenditures are going to be a lot higher than people think, but they have exceeded my expectations,” Jaluria said. “Frankly, I trust Microsoft.” A finance lease is another term for a finance lease.

Microsoft said it gets the best performance and cost by building data centers from scratch. But sometimes the company needs additional capacity immediately, and finance leases can help Microsoft get it more quickly.

The pace has been frenetic since OpenAI introduced ChatGPT in late 2022. Microsoft provides computing power to OpenAI, which means the startup needs enough servers full of Nvidia graphics processing unit to keep ChatGPT online.

With ChatGPT and other OpenAI services growing in popularity, Microsoft has signed up additional cloud providers, including CoreWeave and Oracle. UBS analysts wrote in a September report that comments made by Hood in January suggest that Microsoft’s financial leases include dealings with CoreWeave and Oracle.

Microsoft declined to comment on where third-party cloud partnerships appear in its financial statements.

Jaluria said investors aren’t paying attention to capital lease arrears. Microsoft does not specify when they will take effect or how long they will last, making them less immediate than the quarter’s capital expenditures.

CEO Satya Nadella normally defers to Hood when analysts ask financial questions on earnings calls. But in July, Nadella stepped up when an analyst asked him about his strategy to form partnerships with other cloud providers that complement Microsoft’s direct data center spending.

“To me it’s no different than the leases we’ve done in the past,” Nadella said. “You could also say that sometimes buying from Oracle can be an even more efficient lease because they have an even shorter term.”

When it comes to the jump in capital expenditure and future finance leases, Jaluria said investors just need to accept that they will weigh on profitability.

“Of course, margins are shrinking,” said Jaluria, who has the equivalent of a buy rating on the stock. “The cost is here now, and the benefits are not here to offset it. And I think that’s OK.”