Microsoft: Investors Need To Separate Reality From Hype

Summary:

• MSFT’s post-earnings selloff reversed as dip buyers charged back with unwavering determination.
• Microsoft’s alliance with OpenAI shines with immense potential, yet investors must beware of the ChatGPT buzz as its monetization remains in its infancy.
• MSFT’s premium valuation persists compared to the broader market, yet it’s no longer as steeply-priced.

Last week, Microsoft Corporation’s (NASDAQ:MSFT) FQ2’23 earnings release didn’t cause the stock to fall below its early January lows. Hence, despite a tepid release demonstrating a persistent cloud spending slowdown, bulls could argue that MSFT has likely bottomed.

But does that mean MSFT could revisit its November 2021 highs in 2023? Unlikely. Why?

CEO Satya Nadella was clear in Microsoft’s earnings commentary, highlighting that the pandemic pulled forward significant spending, including in consumer electronics.

With the PC headwinds expected to continue through H1’23 and with little growth momentum potentially till 2024, MSFT’s premium valuation could come under further pressure.

As a leading SaaS player that boasts an adjusted EBITDA margin of 47.8% in FQ2, some investors could argue that MSFT deserves a premium relative to the broad market. However, it also requires Microsoft to return quickly to growth mode before more buyers consider returning, bringing MSFT back toward newer highs.

However, based on Microsoft’s FQ3 guidance, the company is expected to post revenue growth of just 3.3%, in line with the revised consensus estimates of 3.5%.

However, its adjusted EBITDA is projected to decline by 0.2% after FQ2’s 2% downtick. Hence, it’s imperative for Microsoft to follow through on its commitment to “[align] the company’s cost structure with revenue growth,” as MSFT faces a more demanding macro environment.

With companies looking to optimize their IT spending further, Microsoft’s aggressive push to integrate OpenAI’s advanced AI models could be instrumental.

Furthermore, Azure AI services experienced significant growth as management highlighted that “Azure ML revenue increased more than 100% for 5 consecutive quarters.”

However, as companies optimize their spending, Azure’s revenue deceleration is expected to continue in FQ3. As such, while Microsoft’s OpenAI services could drive some hype in the near term, commercialization across its product suites to drive revenue growth remains uncertain for now.

Notwithstanding, Microsoft is confident that it’s leading in advanced AI model development, drawing on its tight-knit partnership with OpenAI. With Azure operating as OpenAI’s exclusive cloud provider, could it drive other companies to look to integrate its models into Azure adoption?

We think it’s critical to note that OpenAI follows the product path in its Large Language Model (LLM) development. As such, it offers “LLM-powered applications through an API. Smaller startups also leverage the power of supercomputer-scale models to fine-tune for specific tasks.”

Hence, there’s potential for more AI-focused companies to incorporate ChatGPT into their product development. For instance, C3.ai (AI) is reportedly integrating ChatGPT into its “C3 Generative AI Product Suite.” But, it’s also important to note that OpenAI’s monetization is in the early stages while consuming significant compute capacity at Azure, courtesy of Microsoft’s cloud credits.

As such, the focus on driving OpenAI’s model is likely laden with significant costs, behooving Microsoft to be able to lift its Azure AI adoption in the near term. Hence, we think that’s a critical area for investors to closely watch, given the significant deceleration in MSFT’s growth momentum.

MSFT is still consolidating below its recent December highs. However, its price action seems constructive, as it robustly held its October lows and recent January lows.

The initial post-earnings selloff has also been rejected by dip buyers, suggesting investors are willing to reverse the steep slide from November 2021.

With an NTM EBITDA multiple of 16.8x, it’s still above its 10Y average of 14.1x. Hence, Microsoft needs to deliver the promise from its OpenAI partnership, which could power Azure into the next growth phase ahead of its hyperscaler peers.

Investors with significant exposure in MSFT can consider waiting for a deeper pullback before pulling the buy trigger. Otherwise, we think the opportunity for better performance in H2’23 should improve if the macro headwinds are less feared, ameliorating the outlook for enterprise spending moving ahead.

As such, picking MSFT at the current levels is still a viable investment.

Rating: Buy (Reiterated).

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Disclosure: I/we have a beneficial long position in the shares of MSFT either through stock ownership, options, or other derivatives. 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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