Microsoft: A Potential Clear Path For Reacceleration In Azure

Summary:

• Azure joined industry-leading cloud providers in the latest earnings season in warning about potential deceleration due to macro headwinds and a shift in enterprise demand for optimization.
• But the swift adoption of generative AI in recent months and Microsoft’s prescient investment in OpenAI could be a competitive advantage for mitigating said risks.
• The rapid adoption of GPT-based technologies and other generative AI solutions is expected to drive incremental cloud demand to Azure, bolstering a 2H recovery story for the stock.

Microsoft’s stock (NASDAQ:MSFT) has been on a steady uptrend, gaining approximately 20% since the release of OpenAI’s ChatGPT, followed by the software giant’s incremental investment into the generative AI firm, and the integration of related technology across various offerings across its line-up. Despite outperforming key market benchmarks like the S&P 500 (SP500) and tech-heavy Nasdaq 100 (NDX) during the same period, the stock’s latest gains continue to trail those observed across its mega cap peers. The lag potentially reflects investors’ angst on anticipated deterioration to Microsoft’s consumer-exposed segments ahead of ongoing tightening of financial conditions, as well as management’s recent warning of deceleration in Azure – a key growth and profit driver.

As discussed in our post-earnings coverage on the stock, Microsoft is set for a stronger recovery in the second half of calendar 2023. This is further reinforced by growing momentum in generative AI and Microsoft’s incorporation of OpenAI’s GPT technology across its key offerings in both productivity software and cloud. Accelerating adoption of GPT technology is also expected to drive incremental demand to Azure, and further narrow its share gap from AWS. With AI adoption now at an “inflection point” and Microsoft playing a critical role in this shift, the company essentially defies concerns over maturation of its sprawling business, and reinforces visibility into a sustained trajectory of organic double-digit growth across its core businesses that count Office 365, Azure and gaming through the long-run.

Microsoft’s Partnership with OpenAI

As discussed in one of our recent coverages on Microsoft, the tech giant has been a key investor in OpenAI since 2019. Following the successful public debut of ChatGPT in November 2022, Microsoft’s incremental investment into OpenAI has preceded the debut of multiple GPT-enabled features across Azure, Bing, Office 365 and Dynamics 365. Azure was also named the exclusive provider of compute power to support OpenAI’s workloads.

Specifically, Microsoft has poured significant capex spend in recent years into the development of supercomputers required to run increasingly complex workloads like those required by OpenAI’s continued research in generative AI. The infrastructure for supporting ChatGPT’s integration into Bing alone has cost $4 billion, while a project aimed at “stringing together tens of thousands of Nvidia’s (NVDA) A100 graphics chips” to build the compute power required for OpenAI’s work cost at least “several hundred million dollars”.

And a “next generation of the AI supercomputer” is already in the works, incorporating some of the latest and greatest data center processors, including the newly introduced Nvidia H100 Tensor Core GPU catered to handling transformer models like GPT-3.5 and GPT-4. The new Nvidia H100 Tensor Core GPUs, configured with Nvidia NVLink Switch System, can link up into a cluster of up to 256, and be “connected to accelerate exascale workloads, [with] a dedicated Transformer Engine to solve trillion-parameter language models”. The combined innovations in H100 are capable of performing “12x faster when handling inferences – that is, how AI responds to real-life queries – compared with the prior generation of A100s at scale in data centers”, and “speed up LLMs by an incredible 30x over the previous generation”, underscoring Microsoft’s aspirations to becoming a “better cloud for AI” in the long-run.

Incremental TAM Expansion for Azure

In addition to the integration of GPT technology across its productivity software and Bing search engine, Microsoft’s Azure cloud unit also benefits from the partnership with OpenAI on the deployment of generative AI solutions in several ways.

Specifically, generative AI is expected to expand the TAM for cloud-computing by driving incremental demand for high-performance computing capacity. While the development and training of LLMs have likely already been factored into the current TAM for cloud, continued deployment of related applications is expected to drive expanded demand.

For instance, the recent integration of GPT technology by companies like Snap (SNAP), Salesforce (CRM) and Instacart will generate additional computing capacity demand from hyperscalers, thus generating incremental cloud revenue. The recent momentum over adoption of generative AI, as observed from management commentaries in the latest corporate earnings season, is also expected to “accelerate the pace of migrating workloads” to the cloud, and alleviate concerns of maturation in the industry as the enterprise cloud spending segment shifts focus towards optimization (discussed here). These together make favourable long-term tailwinds for Azure, as it is currently the exclusive cloud provider for OpenAI – a rapid share gainer in the budding subfield of generative AI.

Mitigating Near-Term Macro Headwinds

Meanwhile, in the near-term, growing momentum in generative AI could also help offset some of looming macro challenges on hyperscaler demand. And Azure has a particular competitive advantage over peers on this front thanks to its prescient investment and partnership with OpenAI.

Recall from our previous coverages that hyperscalers typically operate a consumption-based model, where customers are only billed for capacity used. During an economic downturn, consumption-based models are typically hit first due to the flexibility offered to customers to scale up or scale down usage according to their needs. This is consistent with the slew of warnings from leading hyperscalers – counting Azure and AWS – about an upcoming wave of deceleration in cloud demand as IT spending contracts in response to mounting macroeconomic uncertainties. There is also growing demand for cloud optimization across the enterprise spending segment, which is further weighing on the industry’s profit margins.

But budding demand for generative AI could potentially be the near-term offset to macro-driven headwinds facing hyperscalers’ recession-prone business models. Since its launch, ChatGPT alone has garnered more than 100 million users, and handles more than 10 million queries a day. This underscores the fast-growing opportunity that will be incremental to the existing cloud TAM, which Azure has a competitive advantage in, capitalizing on via its partnership with OpenAI.

In addition to Microsoft’s share of OpenAI’s monetization of ChatGPT and the underlying GPT technologies, the tech giant is also slated to monetize further from ramped up queries on GPT-based platforms over time. Specifically, “Azure OpenAI Service”, which provides Azure customers with access to advanced AI models created by OpenAI, is poised to benefit from incremental demand for “cloud compute and storage” from solutions built on GPT technologies (e.g. Snap’s MyAI, Salesforce’s Einstein GPT). Essentially, accelerated demand for OpenAI’s LLMs and usage of ChatGPT will be critical to fuelling Azure revenue due to incremental consumption of cloud compute and storage capacity, and potentially play a crucial role in mitigating the near-term impacts to its inherently macro-sensitive consumption-based business model.

And over the longer-term, traction gained from Azure OpenAI Service could potentially extend to the cloud unit’s wide-ranging portfolio of adjacent offerings. These include non-GPT related offerings pertaining to AI/ML developments, as well as data storage, management, analytics and security. For instance, Azure OpenAI Service has already encouraged cross-selling to adjacent products like “Azure Cognitive Search”. The AI-enabled platform allows users to better understand and drive insights from their data sets by applying “cognitive skills for vision, language, and speech”. The information can then be leveraged by ChatGPT as a “foundation to answer questions or have a human-like conversation”.

The Bottom Line

Although the near-term macroeconomic outlook has been further complicated by recent turmoil and instability in the global banking system, which suggests that a “soft landing” may have become further out of reach with the ensuing recovery also likely pushed further back, accelerating momentum around generative AI and related deployments could benefit Azure and help mitigate its exposure to cyclical challenges ahead. Beyond the cloud, Microsoft’s foray in generative AI also reinforces a sustained trajectory of organic double-digit growth across its core businesses, one of the key drivers to the stock’s bullish thesis. Microsoft’s recent achievements, paired with expectations for improved margin preservation in the back half of calendar 2023, continue to bolster confidence that the stock remains well-positioned for sustained upside potential over the longer-term.

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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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