Microsoft: Copilot And Cloud To Deliver Next Leg Of Growth

seekingalpha04-30

Microsoft is well-positioned for growth in cloud computing and AI, with its Copilot AI technology expected to be upsold to its large Windows user base.The company's Azure cloud revenue grew by 31% in ...

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a stock that needs no introduction. The firm has been synonymous with PC operating systems since the 1990s. I believe that the firm is poised to enter its next phase of growth, spearheaded by a continuation of secular growth in cloud computing, happening in conjunction with the rise of AI. Specifically, I believe MSFT is the world's best placed company to deploy AI software at scale in the near term. A view endorsed by many, including the highly regarded Wedbush technology analyst Dan Ives. \"Copilot conversions continue exploding with partners/customers lining up for further Copilot deployments to increase efficiencies and profitable growth with more use cases seen across the product portfolio as the AI Revolution heats up\" (Dan Ives, Wedbush)  Microsoft has a windows installed base of over one billion users, and it is my expectation Microsoft will up-sell its Copilot AI over time to this enormous user base. Early indications are that users of Copilot, Microsoft's AI digital assistance, are impressed with the new AI functionality. As part of a pilot study carried out by Microsoft, 77% of Copilot users indicated they did not want to give it up once they had been allowed to trial the technology. Additionally, 70% of respondents said Copilot improved productivity, 64% said they spent less time on email and 75% cited increased speed of information retrieval. I believe Copilot technology will only improve over time and in turn will become a default part of the Microsoft Windows offering. Microsoft is currently offering Copilot for an additional $30 per user, per month. When we consider the sheer size of the Windows installed base, the potential for incremental AI revenue is massive. Macquarie analysts are modelling for a 5% user up-take of Copilot by June 2025. Copilot technology provides a wide range of potential use cases for enterprises, ranging from the use of Large Language Models (LLMs) in security to provide teams with actionable insights to remain secure. To finance where, Microsoft is working with firms like SAP (NYSE:SAP), to reduce labor-intensive tasks such as invoicing. Copilot adoption is moving quickly already, with CEO Satya Nadella stating on Q3 earnings that nearly 60% of Fortune 500 firms are using Copilot in some capacity. In addition, there was a 50% increase, in the level of Copilot assisted interactions in Microsoft Teams. Nadella also noted the product is undergoing continuous improvement, with over 150 new capabilities added to Copilot since the start of 2024 alone. Analysts have been quick to praise MSFT's ability to monetize its AI offering, with JPMorgan analyst Mark Murphy saying \"Overall, we think Microsoft continues to exhibit outstanding execution while simultaneously cementing its pole position as the AI leader and balancing profitability/growth trade-offs\" (Mark Murphy) We see early adopters of copilot already deploying the technology with tangible benefit. The below quote is just one of the many dramatic increases in efficiency which Copilot has been shown to provide for businesses. The proof is in the pudding, as they say, and it is clear that Copilot is being embraced by the first movers. I expect this positive feedback will naturally lead to more businesses adopting the technology. \"Cineplex, for example, built a Copilot for customer service agents, reducing query handling time from as much as 15 minutes to 30 seconds\" (Satya Nadella, Q3 Earnings Call) Cloud In addition to the Windows AI opportunity, Microsoft is a leader in cloud Infrastructure-as-a-Service (IaaS). Microsoft is one of the big three cloud IaaS firms, along with Amazon and Google. They are often referred to as the hyperscalers. The three giant firms control about two-thirds of the cloud IaaS market, with no other firm having even a 5% market share. Microsoft Azure grew faster than peer Google Cloud as per recent earnings. Analysts at Bernstein believe Azure is better positioned to capture AI workloads than its peers, and I suspect this is driving the superior growth. In its most recent earnings, MSFT reported its Azure cloud revenue grew a whopping 31% from an already high bar. Importantly for the AI story, they reported 7% of the 31% cloud growth was specifically related to companies renting cloud capacity to run AI workloads. As we can see, AI is already contributing a meaningful revenue up-lift and I expect this trend to continue. The growth in traditional cloud adoption is far from over, with McKinsey estimating there is still roughly a three trillion dollar opportunity in capturing workloads migrating from traditional on-premises to cloud. Data quality is a key bottleneck for the adoption of AI in business, due to the scale of its installed base, MSFT is sitting on a treasure trove of customer data. Access to information about things such as common email responses, meeting content, excel uses, etc., allows Microsoft engineers visibility into client needs. Thus, Microsoft has the necessary insight into what type of AI products can help customers based upon their usage patterns. Analyst expectations are for continued robust top and bottom-line growth for years to come. Microsoft has been firing on all cylinders under the leadership of Satya Nadella, who has led the successful pivot to cloud and AI since he took the reins in 2014. Under Nadella's tenure, MSFT has delivered a total return CAGR of 28.3%. While it is unreasonable to expect a repeat of such performance given the scale Microsoft has achieved, this is a company with a track record of execution and I expect that continued execution to result in solid stewardship of investor capital and a continued compounding providing healthy returns. As a result, I recommend Microsoft as a strong buy given its track record and clear AI leadership. Recent Earnings Fiscal Q3 earnings beat both top and bottom-line estimates, sending shares higher during Friday's trading session. The results stood out as a stark contrast to Meta (META), which was punished by investors the prior day due to a higher than expected Capex guide. By contrast, Microsoft seemed not to put a foot wrong, with revenue +17% in the quarter and EPS +20%. All business lines showed robust growth with Productivity and Business Processes +11%, Intelligent Cloud +21% and More Personal Computing +17%. Looking under the hood, we saw standout line item performance in Azure Cloud of +31% and Dynamics 365 of +22%. Microsoft Looking ahead to the next quarter (fiscal Q4), management are guiding for robust growth to maintain pace. The standout item is clearly Azure Cloud once again. Expectations are for this business line to grow 30-31% off a high base of comparison. It will be interesting to see the momentum of AI-specific bookings within Azure. A pickup in pace would send a clear bullish signal to investors and further certify Microsoft's AI leadership. Microsoft has now delivered an EPS beat in 18 of the last 20 quarters. When we are considering management's guidance for fiscal Q4, I think we can reasonably assume guidance will at least be met at the high side, if not outright beaten. Valuation For my own assessment of value, I use a two-stage DCF calculation. As Microsoft's full fiscal year-end 2024 is in June, I am using the FY24 estimated EPS as my starting point, given we have plenty of visibility with three-quarters accounted for. I model a medium-term growth rate of 15% and long-term growth of 10% EPS, both are in-line with market consensus. For the discount rate, I consider the likely WACC for Microsoft. The firm is one of only two companies in the world to be assigned a perfect AAA rating from S&P. As a result, the interest payable on debt is trivial, I estimate the average cost of debt to be around 3% as per the below debt schedule from the company's annual report. Microsoft 10-K A firm's cost of equity is inherently more difficult to estimate, as it is not directly observable. Instead, we must infer its value using formula estimates. I am applying the CAPM method, which I have detailed below. My inputs for cost of equity are simple, for the Risk-Free rate I took the latest ten-year treasury bond yield and for the implied equity risk premium (ERP) I use estimates generated by the venerable professor Aswath Damodaran.   Corporate Finance Institute   Author Microsoft has a tiny amount of debt for a firm of its size. When calculating the WACC, we can essentially ignore the debt and simply use the cost of equity as our proxy for WACC. Including the debt would reduce the WACC slightly, but I see no point in being too granular. Warren Buffett famously does not use spreadsheets, so while I think they can be a useful visual tool to aid understanding of a business, we need not get bogged down on granularity.   Koyfin Taken together, we can clearly see the WACC for Microsoft is lower than my chosen 10% discount rate. For DCF purposes, it is prudent to adopt a conservative approach, and hence I am comfortable with 10% as an input. Based on my calculations, I see MSFT as undervalued by about 17% based off the most recent closing price. I model for a P/E at sale of 30x, which is lower than the current multiple and in-line with the five-year average. The stock is up about 8% year-to-date, a solid performance, but hardly shooting the lights out. To be clear, given the sheer scale of Microsoft, I do not expect parabolic growth. However, if like me you are drawn to compounders of the highest quality that you wish to own for many years, then I still think Microsoft is a good portfolio addition, despite having grown to over three trillion in market cap.   Author Conclusion  In conclusion, I think MSFT stock is a name everyone should have in their portfolio. The stock has had an incredible ten years and while I think the days of close to 30% annual returns are behind us, I still believe management can continue to deliver results. The Copilot opportunity is still a nascent opportunity, but it is expected to grow fast, analysts at Piper Sandler think it could represent an additional $10B in revenue by 2026. Taking this and the firm's leading cloud position into account, I expect steady returns from here for this best in-class tech giant.","kind":null,"is_publish_news":null,"is_publish_highlight":null,"is_publish_live":null,"is_publish_wemedia":null,"editions":null,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.22.4","shortVersion":"4.22.4","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2431391405"}