Microsoft’s bid for AI dominance invites government scrutiny
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Microsoft (NASDAQ:MSFT) has been at the forefront of the information technology sector for decades, and it’s now looking to maintain its leadership with big investments in Artificial Intelligence (AI). This technology is creating a paradigm shift in the economy, much as the Internet did in the ‘90s.
Commenting on the company’s performance for its most recent fiscal year ended June 30, 2023, Microsoft CEO Satya Nadella noted, “Because we know that maximum enterprise value gets created during platform shifts like this one, we will invest to accelerate our lead in AI by infusing this technology across every layer of the tech stack.”
The company’s stock has risen 80% from the end of 2022 (recently closing at $427 on June 10), when the publicity about Chat GPT started making news. During this period, the NASDAQ index itself has risen about 65%.
Microsoft’s bid to maintain its leadership position has also attracted antitrust scrutiny from the government. When an inquiry was first launched earlier this year, Federal Trade Commission Chair Lina Khan noted, “As companies race to develop and monetize AI, we must guard against tactics that foreclose this opportunity, Our study will shed light on whether investments and partnerships pursued by dominant companies risk distorting innovation and undermining fair competition."
Strategic relationships
Microsoft’s tie-up with OpenAI, whereby Microsoft has invested $13 billion in the latter and has a 49% stake in OpenAI, allows Microsoft to use OpenAI technology in its products, such as its Bing search engine and Copilot.
According to Microsoft, “We deploy OpenAI’s models across our consumer and enterprise products. As OpenAI’s exclusive cloud provider, Azure powers all of OpenAI’s workloads. We have also increased our investments in the development and deployment of specialized supercomputing systems to accelerate OpenAI’s research.”
Microsoft has also hired most of staff of Inflection AI (an AI startup), and licensed its technology, to build up its own consumer AI business. It seems the structuring of Microsoft’s relationship with OpenAI (owning less than a majority stake) and roundabout pursuit of Inflection (hiring staff rather than acquiring the company) were meant to ward off regulatory scrutiny.
Reaching to the cloud for growth
According to the company, Microsoft generates revenue by “offering a wide range of cloud-based solutions, content, and other services to people and businesses; licensing and supporting an array of software products; delivering relevant online advertising to a global audience; and designing and selling devices.”
On its third quarter (ended March 31, 2024) earnings call for its 2024 fiscal year, Nadella, confirmed that the company is ramping up its capital expenditure, spending by billions of dollars to continuing leading in “this big generational shift and paradigm shift in technology.” The company will continue to allocate the capital required to train AI models to maintain its stake in that space.
For the quarter, the company reported that its revenue of $61.9 billion rose 17% over the 2023 third quarter, while earnings per share was up 20% to $2.94.
Looking at the company’s business segments, revenue in its “productivity and business processes” segment rose 12% in the third quarter to $19.6 billion (up 9% for the fiscal 2023 year), led by quarterly revenue growth of 23% for Dynamics 365, its business applications suite.
According to Nadella, “We are bringing the next generation of AI to employees across every job function and every line of business with Dynamics 365 Copilot, which works across CRM and ERP systems to reduce burdensome tasks like manual data entry, content generation, and notetaking.”
Microsoft’s “intelligent cloud” business segment grew its revenue 21% in the third quarter, with revenue in its Azure cloud and cloud-related services up 31% (revenue rose 17% for fiscal 2023). By using the Azure cloud, businesses are freed from having to manage their hardware at their premises. According to Nadella, while a lot of customers turn to Azure for AI projects, the use of Azure search as a vector database to facilitate AI learning (also used by ChatGPT) is one of the company’s fastest growing services. Azure AI makes available foundation models for businesses to finetune their AI capabilities.
For its “more personal computing” segment, revenue rose 17% for the third quarter, although devices revenue was down 17%. For the fiscal 2023 year, this segment saw revenue down 9%, with devices revenue down 24% as inventory levels were high and PC demand was down.
Microsoft is also looking to incorporate its Copilot generative AI into its products, and Windows PCs, besides making it available to be used on a standalone basis, with the expectation that people will use the software as an assistant for various activities such as learning, shopping, creating and coding.
After security concerns were raised about the use of a “recall” feature that allows Copilot to record a user’s activity on their computer, Microsoft has decided to turn the feature off as a default option.
Strong financials, with some help from accounting change
Like its competitors in the software sector, Microsoft continues to benefit from today’s digital economy, positively impacting its financial performance. For its fiscal 2023 year, Microsoft’s gross profit margin was at a hefty 68%. The company’s debt-to-equity ratio was at a healthy 23%, indicating that it has a manageable level of debt, and also down from 29% for fiscal 2022.
Microsoft’s current assets to current liabilities ratio was at 1.76, saying that it has more than enough assets to cover its liabilities. And, as of the end of the company’s fiscal ’24 third quarter on March 31, its book value per share was about $34, making for a price to book value of about 12.6.
One negative note is that while the company reported earnings per share of $9.68 for fiscal year 2023, up from $9.65 for its 2022 fiscal year, this increase is actually due to an accounting change. Taking into account its investments in software that have led to more efficient operation of its servers and network equipment, as well as advances in technology, Microsoft raised the life of its server and network equipment by two years (which reduces the depreciation associated with these assets). This had the effect of taking up its EPS for fiscal 2023 by $0.40 per share. Without this change, fiscal 2023 EPS would actually have declined about 4% to $9.28.
Don’t bet against Microsoft
Microsoft has rewarded investors so far, even though it lagged for a while by being late to take advantage of the cloud opportunity initially. This time around, it has been early to develop its AI capabilities. Even then it still faces competition for its Office suite, and others such as Google, Apple, Amazon and IBM compete in the cloud space. Amazon and Google are also AI competitors, along with open source solutions such as Meta’s LLaMA3.
Microsoft says, “We believe our cloud’s global scale, coupled with our broad portfolio of identity and security solutions, allows us to effectively solve complex cybersecurity challenges for our customers and differentiates us from the competition.”
Based on earnings for the last 12 months, Microsoft has a price-to-earnings ratio of about 37, which is on the high side. However, besides its growth prospects, the company has continued to reward investors with dividends. It also has a stock purchase program that allows it to buy more than $22 billion of its shares, which should provide some support for its stock price. It seems the company is in a good place to seize opportunity and those who own Microsoft shares could continue to hold them.
There are risks associated with the government scrutiny and any potential legislation that could negatively impact the company. But it’s not wise to bet against Microsoft, which had bounced back after the government’s antitrust case in the 1990s related to the bundling of its windows operating system.
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Note: I do not own any individual Microsoft stock and I do not intend to take a position in the stock within five days of publication of this article. This write up is my unbiased opinion and not intended as financial advice. All investments carry risks and you should talk to a financial advisor to learn about the suitability of an investment for your portfolio. I did not receive any compensation for this piece that influenced my views.