Microsoft: Why I’m Buying The Dip
Contributor since 2020 / 5361 Followers
Summary:
- Microsoft’s diverse ecosystem beyond cloud services, including GitHub Copilot and Copilot Pro, drives AI monetization better than its peers.
- Microsoft’s Q4 performance shows significant growth, thanks to AI integration.
- Despite high CapEx and a 31x forward PE ratio, Microsoft’s dominant market position and AI-driven growth potential make it a strong buy.
jewhyte
Investment Thesis
In our last article, we highlighted Microsoft (NASDAQ:MSFT) as the top public cloud provider poised to cash in on the AI craze. This isn’t because their public AI cloud is a profit machine (let’s be real, none of them are), but because MSFT has a whole ecosystem beyond the cloud where they can make AI pay off. Think GitHub Copilot (that’s $19 a month per subscriber) and Copilot assistance ($30 a month). These are the money makers in the short and medium run.
MSFT Q4 Performance
MSFT’s latest annual report reveals the first full-year impact since OpenAI’s ChatGPT shook the internet. While the company doesn’t break down its Azure services revenue, we can see the new Copilot features fueling growth beyond the public cloud.
Take Microsoft Office for commercial customers, for example. Sales hit a whopping $48 billion, a serious jump from last year’s 10% growth. That’s not a coincidence. Those Copilot Pro subscriptions baked into Office are likely a big part of the story. Even Office for individual users got a boost, with sales hitting $6.2 billion, up 4% compared to last year’s 2% growth, showing that growth is accelerating, defying the law of big numbers.
Segments that haven’t benefited from Generative AI integration such as LinkedIn saw their growth decelerate. LinkedIn sales reached $17.4 billion, a 9% increase, which is a bit slower than last year’s 10.5% growth.
Dynamics Enterprise Resource Planning ‘ERP’ and Customer Relationship Management ‘CRM’ software sales hit $6.3 billion, up 19%, beating last year’s 16% growth. My guess is that customers are switching to Dynamics to take advantage of that sweet Copilot integration in the Dynamics Contact Center platform that allows for automated customer service chatbots that bring significant cost reductions.
Windows sales made a comeback in 2023, raking in $22.7 billion (up 8%). That’s a nice turnaround from last year’s dip. Gaming was naturally up on the back of the Activision Blizzard acquisition. On a consolidated level, Activision accounted for 300 basis points of MSFT’s total 16% sales growth in FY 2024.
Sales from Bing rose to $14.3 billion, up a modest 3%, as the rise of Chatbots continues to pull customers away from traditional search engines.
The not-so-great news is the devices segment, which took a serious hit, dropping to $4.6 billion, down 15% YoY.
Last but not least is the Cloud and Servers segment, which rose a healthy 20% on the back of Azure’s 30% growth. However, Generative AI’s contribution is a mere 8% of that 30% increase in Azure sales, lending us confidence in our initial thesis that the public cloud isn’t the money-printing generative AI machine many people expect it to be.
Thankfully, MSFT, unlike its peers such as Amazon (AMZN), has a comprehensive software offering and subscription-based monetization models to complement its AI offering and increase returns on its GPU investments.
Going forward, we see continued momentum. Digitalization trends that have supported the Azure segment before Generative AI will continue, and maybe accelerate a bit on the back of this new disruptive tech. Dynamics has also been growing its market share since before AI, and with the new Contact Center chatbot offerings, I see this trend gaining momentum. Devices have always been a volatile segment and compete in a cutthroat market dominated by HP (HPQ) and Dell (DELL), who are also MSFT’s largest customers for the Windows segment.
The Bing business line is the hardest to predict. On one side, it could benefit from the design and Copilot integration, which could increase traffic. On the other hand, chatbots from competitors could pull away traffic from traditional search engines, including Bing. In the long run, these details iron themselves out, and as long as MSFT continues investing in its products and infrastructure, it will remain at the center of the tech world.
Capital Spending, Margins, and Valuation
On Wednesday, Satya Nadella made it clear that the Generative AI transition will require substantial resources, including new data centers, knowledge base development, and the ongoing acquisition of GPUs from AMD (AMD) and NVIDIA. CapEx in FY2024 stood at $45 billion, and even more is expected in FY2025.
The significant investment in AI infrastructure raises questions about MSFT’s profit margins. While the company expects double-digit revenue and operating income growth, the increased CapEx will undoubtedly impact profitability. Investors should not expect a significant expansion in margins, as the benefits of the software-as-as-service ‘SaaS’ model are offset by depreciation expenses related to the new capital projects. MSFT’s guidance for FY 2025 suggests continued growth, but operating margins are expected to go down roughly 1%, which shouldn’t be a key driver for the stock’s performance.
When looking at valuation, MSFT is currently trading at a 30.75x forward PE ratio, which isn’t exactly cheap. Still, the company’s dominant position in the tech that powers the entire planet, combined with its growth tailwinds render this a ticker a buy.
Final Thoughts and How I Might Be Wrong
MSFT is down 13% from its peak last month as concerns over the ability of public cloud providers to generate returns on the massive Generative AI investments come into focus. In FY2024, MSFT invested $45 billion on CapEx, but its revenue also benefited from new product roll out including Copilot for GitHub, Copilot for Microsoft Office, Dynamics, and Microsoft Fabric which attracted millions of monthly subscribers. The low token processing prices influenced by OpenAI’s altruistic mission narrow the monetization opportunities for public cloud providers. As mentioned in a previous article, generating the entire content of all books published in 2023 would only bring $17 million to Azure, and even less for AWS, given that Amazon has a lower pricing point. This positions MSFT better than other cloud providers such as AWS in capitalizing on Generative AI, thanks to its suite of enterprise and consumer software products.
Analyst’s 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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