Microsoft: This Time Might Be Different

Summary:

• AI revenues are poised to surge over 2025.
• Microsoft Corporation as a major provider of AI is well positioned to benefit.
• Under Nadella, Microsoft could likely dominate the AI industry.
• We are upgrading Microsoft to a Buy Rating and introducing our new Price Target of $420/share.

Investment Conclusion

We published a Sell-Rating article with a Price Target of $286/share on Microsoft Corporation (NASDAQ:MSFT) last October. The primary drivers of our Sell Thesis were that Wall Street was overestimating MSFT’s potential share of the artificial intelligence (“AI”) market, and that, given MSFT’s history in frittering away first mover advantage (as evidenced with MSN Search and Internet Explorer), MSFT’s AI gains, if any, over the competition, were likely to be fleeting.

We stand behind our contention that MSFT is unlikely to corner the AI market. Although the firm reported strong AI revenues in its fiscal Q2, as part of its cloud computing segment (as most AI is distributed through the cloud), financial outcomes associated with Amazon’s (AMZN) and Alphabet’s (GOOG) cloud computing segments were solid as well. Nevertheless, given the AI outperformance associated with the three companies, it appears that the technology industry pie, driven by AI, is expanding, by a lot. There will be enough growth to go around, in our opinion.

In addition, MSFT’s long-term business performance under CEO Satya Nadella might be better than that experienced under predecessors Bill Gates and Steve Ballmer. Further, MSFT posted an outstanding F2Q24, and also for the six months ended December 2023. Further, it provided strong financial guidance for F3Q24. Considering, these elements, we are more bullish on MSFT than we were last October.

Therefore, we are updating inputs to the 10-year Discounted Cash Flow (“DCF”) model, utilized to derive MSFT’s intrinsic value. Our average revenue growth rate increases to 16% from the prior 12%, the operating cash flow margin expands to 46% from the previous 42%, and capital expenditure margin declines to 12% from the earlier 14%. Based on the changes, we arrive at a new Price Target of $420/share for MSFT. Upgrading our Rating to Buy from the prior Sell.

Investment Thesis

Last Tuesday, MSFT reported strong F2Q24 and six months ended December 2023 financial results. For the second quarter, on a year-over-year basis, revenues expanded 18% to $62 billion, operating income increased 33% to $27 billion, net income advanced 33% to $22 billion, and earnings per share escalated to $2.93 from $2.20. Relative to the same period over the previous year, revenues related to the Intelligent Cloud segment expanded by 20% to $26 billion, driven primarily by 30% growth in Azure revenues. Operating income associated with the Intelligent Cloud business advanced by 40% on a year-over-year basis to $13 billion.

For the six months ended December 2023, compared to the same period in 2022, revenues expanded 15% to $119 billion, gross profits increased 18% to $83 billion, operating income advanced 29% to $54 billion, and net income escalated 30% to $44 billion. During the period, gross margins were flattish at 70%, operating margins expanded 400 bps to 45%, and net profit margins increased 430 bps to 37.3%. On a year-over-year basis, revenues associated with the Intelligent Cloud category advanced 20% to $50 billion, and operating income linked to the segment increased 40% to $13 billion.

MSFT through its $1 billion investment in OpenAI in 2019, was early to the AI party. The company struck pay dirt when OpenAI launched its generative AI large language model chatbot, ChatGPT, in November 2022. MSFT, given its affiliation with OpenAI, was well positioned to capitalize and rapidly integrated ChatGPT into its Bing search engine, rendering the firm a front-runner in AI. MSFT kept the momentum going, swiftly following up by embedding AI-powered assistants called Co-pilots into its entire technology stack, from Windows, to Office, to Azure.

In addition, MSFT heavily self-promoted its AI capabilities, implying dominance of the AI industry. Therefore, although, AMZN and GOOG, introduced products rivaling MSFT’s AI offering, the perception that MSFT was the leader in AI persisted. The combination of events culminated in MSFT capturing 2% of the cloud computing market, from AMZN, in the December quarter. Clearly, MSFT has secured first mover advantage in AI. However, whether the company can hold on to its AI gains is uncertain.

AMZN’s and GOOG’s business dynamics suggest that their respective AI related ventures are likely to take off over 2024. Client optimizations are complete at AMZN’s AWS, and GOOG plans to integrate its latest foundational large language model (“LLM”), Gemini, into its AI tools, improving performance and reducing latency. For 2023, compared to 2022, AWS revenues increased 13% to $91 billion, and operating income associated with the business expanded 7.8% to $24 billion. Google Cloud revenues advanced by 25.9% to $33 billion, and operating income expanded by 186% to $1.7 billion. For six months ended December 2023 compared to the same period in 2022, revenues related to MSFT’s Intelligent Cloud business, increased 20% to $50 billion, and operating income expanded 35% to $24 billion. Undoubtedly, MSFT is firing on all cylinders, in regards to AI, as part of its cloud computing segment.

Still, optics appear to favor AMZN and GOOG. AMZN, with 31% of the cloud computing market share (vs. MSFT’s 23% and GOOG’s 11%), has the largest base of customers to upsell its AI tools and services to. GOOG, with its outsized amount of customer data is positioned to benefit (as data is primary to AI). However, AI development is far from complete, significant improvements and advances are on the horizon. In addition, market uptake of AI remains in the nascent stage. Given Gartner’s projections that by 2025, on a world-wide basis, 90% of companies will provide their workforce with AI assistants, half of the firms will achieve AI maturity (as in will have figured out appropriate use cases for AI in their organizations), and that AI as a feature of cloud computing will have expanded by a factor of five, it appears that AI revenues are likely to achieve reasonable velocity, only next year. Statista estimates that by 2030, AI revenues will advance to $740 billion compared to $242 billion generated in 2023, representing an annual growth rate of ~50%.

Further, there is the Nadella effect. The current CEO of MSFT, Satya Nadella, has certainly proven to be head and shoulders above his predecessors, Bill Gates (who effectively lost the search and browser races for MSFT) and Steve Ballmer (who was instrumental in MSFT missing out on mobile to the advantage of Android and iOS). On ascension to top boss, Nadella introduced a softer, more conciliatory MSFT. One that touts empowering organizations and people to achieve more. One that favors collaborating with competitors for mutual benefit. Under Nadella, MSFT has developed successful partnerships with Apple (AAPL), Salesforce (CRM), International Business Machines (IBM), and Dropbox (DBX), among others. Nadella has inked mega deals, acquiring LinkedIn, GitHub, Minecraft, and Activision Blizzard, significantly expanding MSFT’s total addressable market (“TAM”).

In 2014, MSFT was considered washed up, excluded from key conversations about technology. Under Nadella’s watch, driven in part by the success of the company’s cloud computing business, MSFT’s market capitalization has expanded to ~$3 trillion from ~$300 billion in 2014. Revenues have increased at an average annual growth rate of ~27% during Nadella’s tenure as CEO, following 14 years of flattish revenue growth. Undoubtedly, he has outperformed for MSFT. Considering Nadella’s strong leadership skills, he might possess the ability to establish MSFT as AI front-runner. At the minimum, the company could just as easily dominate AI, as AMZN or GOOG.

Moreover, financial guidance for F3Q24, appears solid. On a year-over-year basis, revenues associated with the Productivity And Business Processes business are expected to expand by 10% to 12%, that related to Office 365 by 15%, Office Consumer and LinkedIn by mid-to-high single digits each, Dynamics by mid-teens, Intelligent Cloud by 18% to 19%, Windows Commercial Products And Services by mid-teens, Search and News by high-single-digits, and gaming by 40%. Considering MSFT’s financial outperformance over the front half of FY24, and the strong business outlook for F3Q24, it appears likely that the firm will report outstanding FY24 financial results.

Net-net, the narrative presented above suggests that this time might be different for MSFT. The company could probably experience strong revenue and earnings growth over an elongated time horizon. Therefore, we have turned constructive on MSFT.

Bottom Line

With the advent of AI, major technology companies are experiencing a “rising tide lifts all boats” moment. AI represents a paradigm shift for the technology industry. Businesses of large technology firms will be overtaken by AI. AI will be integrated at all levels of technology stacks, of big technology companies. Considering the dramatic revenue growth opportunity associated with AI, major technology firms are positioned for an earnings windfall. The technology industry pie has grown larger, a lot larger. Microsoft Corporation, given its business conditions, appears to represent an appropriate investment to benefit from the AI revolution. We suggest investors accumulate the firm’s shares on pullbacks.

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Analyst’s 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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