AI: Microsoft a microcosm for broader AI debate. RTZ #502

...despite an AI lean-in strategy, near-term doubts rise externally

I’ve highlighted for some time now, the ongoing debate on Wall Street on AI investments and opportunities by the big tech ‘Mag 7’ companies as they lean into the growing ‘AI Table Stakes’. While investors are for the most part buying the long term opportunities in this AI Tech Wave, near-term concerns keep coming back on the timing of AI revenues and profits.

Nowhere is this debate more relevant than Microsoft and Copilot, which as OpenAI’s core partner, remains in pole position on the AI opportunities ahead. Although Meta, Amazon, Google, Apple, xAI/Tesla and other also have major AI initiatives in play, Microsoft has perhaps leaned in the most. CEO Satya Nadella has been relatively unique in his early conviction on his ‘AI wager’. Including the diversification of his AI strategy.

Nvidia of course is a separate case since their ‘revenues are everyone else’s expense’. They’re selling the AI pickaxes and shovels in this Ai gold rush, a point discussed often here.

The WSJ gives Microsoft its ‘closeup’ on the AI front, in “Microsoft’s AI Story Is Getting Complicated”, worth reading in full as a microcosm of the broader AI debate. Some highlights:

“Blowout capital spending, financial reporting changes and the relationship with OpenAI are making investors think twice.”

“Big tech’s AI champ is looking a little battered these days.”

“Microsoft MSFT was an early mover on generative artificial intelligence, and investors benefited handsomely. The software company’s stock surged nearly 57% last year in its best annual performance since 1999, according to FactSet data. But the cold splash of reality that AI stocks have received over the past few months has been particularly chilling for the company that helped introduce the world to ChatGPT. Microsoft’s year-to-date performance of less than 11% lags behind all other megacap techs and the S&P 500. It is also the only one in that crew to trail the Dow Jones Industrial Average for the year.”

“There is a mix of reasons. Microsoft’s business is indeed booming. Revenue of $245.1 billion for the fiscal year that ended in June was up nearly 16% from the previous year and a record, while the company’s annual operating margin of 44.6% for the year was its highest since 2001—when the business was about 10% of its current size—according to data from S&P Global Market Intelligence. “

“But keeping its lead in the AI race is proving expensive—even for a company of Microsoft’s vast resources. Big tech companies have boosted spending on AI technology across the board, but Microsoft’s surge still catches the eye. Capital expenditures combined with equipment leases totaled $55.7 billion in the recently ended fiscal year. That is 23% of the company’s reported revenue for the year, up from just 14% of revenue over the previous five years.”

The discussion of course then shifts on impact on their financials as the returns come meaningful after the investments:

“That spending has a cost. Analysts expect Microsoft’s free cash flow to rise only 3% this year compared with a 25% jump the previous year. And since a lot of that spending will be going to AI infrastructure—like Nvidia’s expensive chips and the liquid cooling systems required for the latest of them—Microsoft will also face higher depreciation charges against its earnings. In an Oct. 3 report, Keith Bachman of BMO Capital Markets said Microsoft’s “elevated levels of capex and thus depreciation may limit margin expansion in the near and medium term.” 

“There is also the question of what that spending will actually yield. Microsoft has so far not disclosed specific revenue from generative AI offerings such as its Copilot tools, though Hood said in the last call that the 29% year-over-year revenue growth for the company’s Azure cloud service in the latest quarter included 8 percentage points from AI services. Keith Weiss of Morgan Stanley wrote in an Oct. 1 report that “investor patience appears to be wearing thin for GenAI to inflect revenue growth trend-lines more positively in the space.” 

“Recent financial reporting changes by Microsoft might shed a little more light on the matter—or less. The changes, announced on Aug. 21, shift revenue around the company’s business segments and will effectively lower revenue for the closely watched Azure cloud business but also boost the reported growth rates there, according to an analysis by Mark Moerdler of Bernstein.”

And then there is of course the perceived exposure risk from the OpenAI relationship:

“Microsoft’s perceived dependence on OpenAI might also be a bit of a liability. The company participated in the latter’s mammoth fundraising round that closed this last week and previously invested $13 billion—making it OpenAI’s largest outside stakeholder. But OpenAI is also experiencing a new bout of turmoil, with several high-profile executives recently departing as the outfit begins a shift toward becoming a for-profit company.”

“The close partnership with ChatGPT’s developer also hasn’t insulated Microsoft from worries about its competitive position. In a rare downgrade of the stock to a neutral rating, Gil Luria of D.A. Davidson said that “competition has largely caught up with Microsoft on the AI front, which reduces the justification for the current premium valuation.” About 93% of analysts rate the stock as a buy, indicating that Wall Street is still inclined to give the $3.1 trillion software giant the benefit of the doubt. Microsoft just has to make sure those doubts don’t grow.”

All the above are relatively predictable in terms of both side of the AI ledger for Microsoft, and its partnership with OpenAI. Especially as overall competition increases despite the wide open new markets.

I of course, continue to view the overall AI opportunities are more positive than negative, but patience of course will be required. And these debates will likely get louder before investors get answers with more clarity in this AI Tech Wave early days. Stay tuned.

(NOTE: The discussions here are for information purposes only, and not meant as investment advice at any time. Thanks for joining us here)