BACRP - Microsoft 2.0: AI Could Drive Massive Revenue Growth

2023-06-10 05:28:47 ET

Summary

• Microsoft's AI-powered tools like GitHub Copilot and Office 365 offer enhanced productivity and efficiency, opening up new revenue streams and driving growth.
• MSFT is expected to extend AI Copilot functionalities to other platforms, such as Dynamics and Azure, further increasing demand for its AI solutions.
• Microsoft's solid financial performance, robust margins, and healthy FCF projections make it an attractive investment option despite its higher valuation compared to some peers.

We have long been bullish on artificial intelligence and are one of the first investors to write about the potential of ChatGPT-like technologies transforming Microsoft (MSFT). The AI industry has experienced rapid growth, and there is a lot to share with our readers. In this article, we explore the potential of generative AI technologies like ChatGPT and how they could enhance Microsoft's competitive advantage, drive revenue growth, and deliver substantial returns for investors. We'll also delve into Microsoft's financial performance and valuation, painting a comprehensive picture of the company's position in the AI landscape.

GitHub Copilot: Early Success With AI-Driven Revenue Uplift

Since its release, GitHub Copilot has transformed developer productivity for more than one million people, helping developers code up to 55% faster .

The advent of AI-enabled products like GitHub Copilot signifies an exciting frontier in Microsoft's growth strategy. Launched in late 2021, GitHub Copilot offers two tiers of AI-enabled service, with individual users being charged $10 per month, and businesses being charged $19 per user per month. This pricing significantly exceeds the costs for the GitHub Free and GitHub Team options, which are priced at $0 and $4 per user per month, respectively, and it sits just below the cost for GitHub Enterprise at $21 per user per month.

Given this pricing structure, GitHub Copilot represents a substantial revenue-generating opportunity for Microsoft. It stands to reason that customers, both individual and business, will find the AI-powered capabilities of GitHub Copilot to be an appealing proposition, as these AI-enhanced features are designed to streamline operations and enhance productivity.

Moreover, by placing GitHub Copilot in a price range that's competitive with GitHub Enterprise, Microsoft is likely to attract users who are interested in sophisticated, AI-powered tools but may not require the full suite of features that comes with the Enterprise version. The enticing promise of AI-driven capabilities, combined with reasonable pricing, could thus serve to drive significant upticks in subscription rates.

Consequently, we posit that Microsoft's foray into AI-enabled products like GitHub Copilot not only places the tech giant at the forefront of technological innovation but also holds the potential to unlock substantial revenue growth. These AI-integrated offerings represent a new and promising revenue stream for Microsoft, capable of bolstering the company's overall financial performance.

A Major Step Towards AI Monetization: Office 365's Path To 40% AI-Driven Revenue Uplift

As we dive into recent developments at Microsoft, we can't overlook the impressive move the company has taken to test a new AI-enhanced version of their flagship product, Office 365. This upgrade is currently being piloted by more than 600 of Microsoft's top-tier clients, a diverse pool that includes heavyweight corporations like Bank of America ( BAC ), Walmart ( WMT ), Ford ( F ), and Accenture ( ACN ), according to a recent The Information report .

An intriguing aspect of this development is that a select group of at least 100 customers are presently subscribing to this new offering at a fixed annual fee of up to $100,000, encompassing up to 1,000 users. The implication here is clear - businesses are willing to pay at least a 40% premium for this AI-powered upgrade over the traditional Office 365 package.

The crux of this premium pricing lies in the advanced features Microsoft has woven into this product. The AI functionality promises to supercharge productivity, automating tasks such as text drafting in Word or slide creation in PowerPoint presentations, simplifying operations and increasing efficiency for users.

Microsoft 365 has seen an innovative update in the form of Copilot integration. This feature enhances user experience in two primary ways. Firstly, Copilot is directly embedded within the applications, augmenting their usability and enabling users to maximize value. Secondly, it includes a Business Chat function that supports natural language prompts across the Learning Language Model (LLM), Microsoft 365 applications, and data, effectively bolstering productivity.

Thanks to Copilot, users can swiftly perform tasks such as data analysis in Excel, PowerPoint presentation development, creating text for Outlook emails, summarizing Teams notes, and building Power Automate flowcharts. Each of these tasks can be accomplished in mere seconds. After Copilot provides a draft output, users can choose to either accept it, revise it slightly, or disregard it entirely. This capability marks a major departure from traditional software interactions, offering users more flexibility and control.

While users will still need to vet Copilot's outputs carefully, the time-saving benefits offered by this AI-enabled assistant are substantial. This fresh approach to software interaction could be a game-changer, setting a new standard in user experience and productivity enhancement.

This product launch is a strategic attempt by Microsoft to monetize its significant $10 billion investment in OpenAI. Office 365, a cornerstone product for Microsoft and an essential tool for business operations globally, boasts an established user base of 345 million users existing in 2022. By integrating AI capabilities into such a well-regarded product, Microsoft is tactically placing its cutting-edge technology where it can have maximum impact.

Given the existing popularity of Office 365 and its widespread usage, even a modest uptick in adoption rates for the AI-enhanced version could result in significant incremental revenue. This clever move could well pay off, contributing materially to Microsoft's revenues and surpassing current forecasts. This strategy by Microsoft to leverage their investment in AI demonstrates their commitment to innovation, and it may well shape the future trajectory of their growth.

More To Come

At this stage, we fully expect Microsoft to extend the AI Copilot functionality to its Dynamics platform. This expansion would be a logical progression, as Dynamics has a significant user base that could greatly benefit from the enhanced productivity and efficiency offered by AI-powered tools. Dynamics is a robust platform for CRM and ERP solutions, and the integration of AI Copilot would boost its capabilities even further. With AI assistance, users could manage and analyze customer and business data more effectively, improving decision-making and potentially driving more significant growth.

Beyond this, the increased demand for AI-powered solutions also bodes well for Microsoft's Azure. As Microsoft's premier cloud computing service, Azure could see increased usage as more businesses adopt AI technologies. Azure's sophisticated infrastructure is crucial for supporting AI workloads and services, from machine learning to natural language processing. Increased demand for these services could lead to greater Azure adoption and usage, thereby driving up revenue.

Furthermore, with AI Copilot acting as a visible and practical demonstration of AI's potential, we could see a heightened interest in AI solutions. This curiosity could lead to more companies exploring Azure's extensive suite of AI services. In essence, the successful rollout of AI Copilot could serve as a compelling advertisement for Azure's broader AI capabilities, leading to increased customer acquisition and revenue growth.

Financial & Valuation

Note: All historical data in this section comes from the company's 10-K filings, and all consensus numbers come from FactSet.

As we examine Microsoft's recent financial performance, it's impossible to ignore the company's impressive performance in the last earnings report, which led to a stock price increase of 7.2%. Revenues for the quarter were up 7.1% year on year to $52.9 billion, surpassing consensus estimates by 3.6%, a clear indication of the company's strength and growth trajectory. The substantial gross margin of 69.5% and an operating margin increase to 42.3% from 41.3% a year ago provide further evidence of the tech giant's excellent command of its business operations.

When we look at MSFT's financial trends, the robust annual revenue growth rate of 16.4% over the past three years stands out. Although the sell-side consensus anticipates a slightly slower growth pace of 6.7% this fiscal year, reaching $211.5 billion, the forecast for the following year is a robust 11.6%, amounting to $236.0 billion. We find this slowdown somewhat concerning but note that the anticipated acceleration in the following year is a promising sign of the company's enduring growth potential.

Turning to the EBIT margin, MSFT's consistent improvement is impressive, with a gain of 7.9% points from 34.1% to 42.1% over the past three years. Though there's an expected contraction to 41.4% this fiscal year, the projected expansion to 42.2% in the following year tells us that MSFT is likely to maintain its profitability.

We also notice MSFT's keen attention to shareholders' interests, with management effectively leveraging share repurchases to offset shareholder dilution. This is evidenced by the 2.0% decrease in diluted outstanding common shares over the last three years, during which the company spent 3.7% of its revenue on share-based compensation (SBC).

The consensus free cash flow forecast for the current fiscal year is $59,511 million, yielding a 28.1% FCF margin. While this is lower than the 30.3% FCF margin seen four fiscal years ago, it remains a strong indicator of the company's healthy cash position. This is further substantiated by the company's average FCF margin of 33.0% over the last four fiscal years.

Regarding capital expenditure, MSFT's average capex as a percentage of revenue over the same period was 12.1%, indicating a high level of capital intensity in its operations. This is no doubt driven by the high growth of its public cloud business, Azure. Nonetheless, the strong return on invested capital at 32.2% and the net cash position of $56,217 million indicate that MSFT is more than capable of managing these expenses.

The current dividend yield of 0.8% is lower than the S&P 500's dividend yield by 67 basis points, a factor income-focused investors may wish to consider. MSFT's stock, currently trading at $326.79, has an impressive absolute return of 21.4% over the past year, outperforming the S&P 500 by 15 percentage points.

Despite a PEG ratio of 2.4, a premium of 45.6% relative to the S&P 500, and the fact that MSFT is currently trading at valuation multiples higher than the S&P 500 across EV/Sales, EV/EBIT, P/E, and FCF metrics, we believe that the company's consistent growth justifies these premiums. It is notable that short interest is low at 0.6%, hinting at limited market skepticism about MSFT's prospects.

From a historical perspective, the stock's current forward 12-month P/E ratio of 29.7 is higher than its five-year average of 27.0, positioning it on the higher end of its historical valuation spectrum. However, compared to its 2-standard deviation range of 19.8 to 34.2, MSFT's current valuation appears moderately placed. It's essential to note, however, that quality often comes at a premium, and in MSFT's case, we believe that premium is warranted given its consistent and robust growth trajectory.

Shifting our focus to peer comparisons, MSFT's forward 12-month P/E ratio of 29.7 appears relatively conservative when stacked against ServiceNow's ( NOW ) hefty 50.7 P/E. However, it's considerably higher than the ratios for Adobe ( ADBE ) and Salesforce ( CRM ), which stand at 26.6 and 26.3, respectively. These discrepancies underscore MSFT's unique position in the technology sector-balancing high growth and robust margins, and justifying a somewhat elevated P/E ratio.

To sum up our analysis, MSFT has demonstrated consistent and strong financial performance. While the company's revenue growth forecast for this fiscal year is marginally lower than previous years, its impressive operating margin, strategic share repurchases, and healthy FCF projections are all encouraging signs for potential investors. Despite its somewhat lofty valuation compared to its historical averages and some peers, we believe that MSFT's continued growth and solid operational command justify its current price. Given these factors, we remain optimistic about MSFT's prospects.

Conclusion

The advent of AI and its application in Microsoft's offerings like GitHub Copilot and Office 365 signifies a bold leap into the future, promising substantial returns for investors. These AI-powered tools not only enhance user productivity and efficiency but also open up lucrative new revenue streams for the company. As Microsoft continues to innovate and lead the AI space, it is primed for sustained growth.

Furthermore, we believe the company will extend AI Copilot functionalities to other platforms such as Dynamics and Azure. This approach is likely to spur further demand for its AI-powered solutions, thereby boosting its revenue.

Microsoft's solid financial performance and robust margins, along with its strategic share repurchases and healthy FCF projections, indicate a promising future for potential investors. Despite its higher valuation compared to some peers, Microsoft's consistent growth trajectory justifies its price premium. As the company continues to pioneer AI's development and application, we maintain an optimistic outlook on its potential to deliver substantial investor returns.

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