Microsoft Corp. (MSFT, Financial) reported strong earnings for the fourth quarter of fiscal 2023 on July 15, but its stock declined more than 2% in after-hours trading, followed by a decline of more than 3% on July 26.
The company topped analyst estimates for both revenue and earnings, but investors are seemingly focused on the substantial investments the company has made to drive the growth of its artificial intelligence business unit. A closer look at the company’s cloud business and AI-related investments reveals Microsoft still has a long runway for growth.
The cloud business is booming
As many investors and analysts expected, the Intelligent Cloud business, which comprises Azure revenue, delivered strong results for the quarter and full year. In the fourth quarter, revenue from this segment came in at $24 billion, a 15% year-over-year increase. Azure revenue grew by 26%, highlighting the strong momentum behind the company’s cloud business.
In the cloud sector, Microsoft has emerged as a reliable player that offers both platform-as-a-service and infrastructure-as-as-service solutions. The company’s diversified cloud product offering continues to attract new clients, enabling it to set a foundation to build long-lasting competitive advantages. The company is competing with Amazon.com Inc.'s (AMZN, Financial) AWS and Alphabet Inc.'s (GOOG, Financial) Google Cloud.
A comparison of these cloud products reveals Azure enjoys certain advantages over its peers. For example, Azure becomes an automatic choice for many companies that already use Microsoft’s Office products and Teams for collaboration. Further, it is compatible with .Net applications and the company has a strong track record of prioritizing the security of confidential data that goes back decades.
For businesses that are migrating to the cloud, the most distinct advantage of using Azure for this transition is that their existing data can seamlessly be transferred from various Microsoft products to the cloud. Customers, therefore, will be using a product they are already familiar with. The company is capitalizing on this advantage by cross-selling cloud products to customers who are using its other products and services.
With the global cloud transition still at an early stage, Microsoft Azure has a long way to go. The Intelligent Cloud segment has already become the biggest contributor to Microsoft’s revenue and should enjoy many years of growth before any slowdown occurs.
AI investments will create value
One explanation for the muted market response to Microsoft’s strong earnings is that investors are fearful of its aggressive AI investments. In the June quarter, capital expenditures increased to $10.7 billion from $7.8 billion in the previous quarter, in line with management's guidance for a continued rise in capital expenditures in the foreseeable future as it tries to make the most of its first-mover advantages in the generative AI segment.
These investments have enabled the company to begin integrating AI into many of its products, including Azure, Microsoft 365 and GitHub, paving the way for the software tools to gain an edge over their competitors.
Investor fears about Microsoft’s aggressive investments seem to stem from the fact that similar investments by Meta Platforms Inc. (META, Financial) to pursue a future in the metaverse created a massive dent in its operating margin last year, which in turn led to a sharp decline in its market value. However, in Microsoft’s case, the playing field is different as the company is well-positioned to reap the rewards of these investments in both the long run and the short run.
For example, the Azure OpenAI Service, which allows users to apply large language models and generative AI to a plethora of use cases, is now being accessed by more than 11,000 organizations. According to CEO Satya Nadella, this service added nearly 100 new customers, on average, each day in the most recent quarter. This is a clear indication of how Microsoft’s strategic investments in AI are helping it gain an edge over competitors even in the short term.
There are many early signs of Microsoft’s AI investments delivering immense value in the long term. Microsoft Fabric, a service that unifies compute storage and governance, has gained 8,000 trial users in its first month. Azure AI Studio, which helps companies fine-tune AI models, has also gained traction, with Github Copilot sign-ups exceeding 270,000 in the June quarter. More than 63,000 organizations have now used AI capabilities in Power Platform as well, and Power Automate now has more than 10 million monthly active users.
Microsoft 365 Copilot, which brings AI capabilities to popular office applications such as Word and Excel, will be another driver of revenue in both the short and long term. Jefferies analyst Brent Thill recently wrote in a report that Microsoft 365 Copilot could help double Office 365 Commercial revenue in the next five years.
The company is seeing stellar growth across almost all the AI tools and services it has launched in recent months, which suggests the investments have already begun to pay off.
Takeaway
The negative market reaction to Microsoft’s fiscal fourth-quarter earnings report does not accurately reflect the progress the company has made in commercializing its AI products. As the frontrunner in developing mass AI applications, it is well-positioned to earn handsome returns from its AI investments.
Although Microsoft is not cheaply valued with a forward price-earnings ratio of 32, it deserves to trade at premium valuation multiples because of its early dominance in the AI sector and the growth prospects for the cloud business.
