David Becker
Microsoft Corporation (NASDAQ:MSFT) has upped the ante on generative AI as it heads into its fiscal second-quarter or FQ2’24 earnings release on January 30. MSFT has outperformed my expectations since my previous October 2023 update, as buyers continued to defy gravity. It’s important to consider that MSFT last traded at a forward EBITDA multiple of 22.8x, well above its 10Y average of 15.4x. Considering MSFT’s implied overvaluation relative to its 10Y average, should investors continue to join the recent buying fervor or wait patiently for an elusive steep pullback?
Observant investors should be cognizant of Microsoft’s AI lead through the infusion of its Copilot across its products. It has recently furthered its efforts to increase adoption in individual users and smaller businesses, following the relative success of its previous commercial launches. As a result, Microsoft has gained more credibility in its ability to monetize its AI offerings, helping to mitigate the increased CapEx and operating expenses for its AI offerings.
Investors shouldn’t understate the CapEx and running costs for developing and running these models. As a result, Microsoft’s ability to monetize and bundle its AI offerings with its existing product suites is a highly significant competitive moat to fend off competitive pressures from its hyperscaler peers. The race for companies to embed AI into their products and workflow has also gained traction with the leading banks, “known to be among the stingiest software buyers, also are increasingly embracing the technology.” As a result, the AI hype is only without substance if there’s no way to monetize them effectively. However, as Wedbush highlighted recently, Microsoft is well-primed to spread the adoption of AI across its installed base “over the next three years. Use cases are going to be rolled out over the next three to six months.” In other words, AI is a hype that Microsoft is well-positioned to leverage and capitalize against its peers, given the scale of its SaaS installed base.
To make things clear, OpenAI CEO Sam Altman articulated in a recent interview at the World Economic Forum at Davos that the AI company is focusing on “launching the next version of the company’s large language model, likely to be called GPT-5.” However, he lamented that the energy requirements for these models are massive, stressing that “developing these bleeding-edge models will likely require a significant energy breakthrough due to the vast power consumption needs of AI development.”
Given the recent job cuts, Google (GOOGL) (GOOG) Sundar Pichai made it clear why the company will continue to reorganize its workforce. Pichai indicated that the changes underscore the “tough choices” that Google has to contend with, as it “prioritizes artificial intelligence.” Accordingly, Google intends to invest more significantly in AI CapEx while rushing to “launch and commercialize its Gemini large language model.” Meanwhile, Pichai has had to deal with fending off defections to OpenAI from its DeepMind unit, which is pivotal to Google’s Gemini LLM efforts.
As a result, I believe it has positioned Microsoft excellently in the AI race as Amazon Web Services (AMZN) reportedly stumbled in its attempt to catch up with the leading duo. In addition, Microsoft’s close partnership with OpenAI has provided the company with a significant lead, bolstered by the AI PC refresh opportunity over the next two years.
The wide adoption of Microsoft’s SaaS products has also allowed the company to bundle its offerings to enhance adoption. Microsoft’s “advantage” in this aspect has been viewed with an “anti-competitive” perspective by its arch-rivals. However, with Azure continuing to drive significant growth for Microsoft (FQ1: 29%), it should be clear that customers aren’t seeing as many issues with bundling as Microsoft’s competitors see it. The Information aptly highlighted:
What do customers think about the practice? One answer might be that they like the bundles. And the lack of a mass revolt over Microsoft’s bundling could make it harder for rivals to prove that customers would rather buy their products and only pay for the Microsoft services they want. That’s a key factor in whether the government or courts determine that Microsoft’s conduct violates the law. – The Information
As a result, all eyes are likely on the adoption rate of Microsoft Copilots through its product suites. Microsoft CMO Takeshi Numoto is “closely analyzing customer demand to determine whether to bundle them with E3 or E5 or maintain them as a stand-alone offering.” In other words, Microsoft will likely follow its tried-and-tested bundling strategy to gain a further edge against its hyperscaler peers and smaller enterprise SaaS rivals, built on a solid foundation with OpenAI’s market-leading models.
Therefore, the point of Microsoft as the AI market leader with a proven ability to monetize doesn’t seem to be in doubt. MSFT’s implied overvaluation appears to reflect my observation. Based on MSFT’s FY26 EBITDA multiple of 17.3x, it suggests that the market has priced in two solid years of AI execution. My point is that you could be late if you have not added MSFT to your portfolio. Although MSFT could continue to benefit from near-term upward bias, the risk/reward of continued outperformance from the current levels seems increasingly unattractive.
Takeaway
Microsoft is a high-quality SaaS company that should form the foundation of tech and growth investors’ portfolios. However, the market knows it, too, suggesting why it has likely reflected two solid years of performance in its valuation, as highlighted earlier. Microsoft needs to execute impeccably to justify its valuation. While I’m not betting against CEO Satya Nadella and his team, I believe the margin of safety isn’t attractive for me to encourage MSFT investors to add more exposure at the current levels.
Rating: Maintain Hold.
Important note: Investors are reminded to do their due diligence and not rely on the information provided as financial advice. Please always apply independent thinking and note that the rating is not intended to time a specific entry/exit at the point of writing unless otherwise specified.
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