Siebert Financial Corporation

10/31/2024 | Press release | Distributed by Public on 10/31/2024 06:55

Can Microsoft Keep Up with AI Demand? Analyzing Earnings and Future Prospects

Can Microsoft Keep Up with AI Demand? Analyzing Earnings and Future Prospects">

Stocks closed in the red yesterday as fears of tech earnings misses rose to the surface. Amidst all the chaos, consumers rose to the podium, crowned champions, after carrying Q3 GDP to a respectable +2.8%.

Build it and they will come. Have you heard about AI? Of course, you have. Even the 41% of Americans who don't own computers along with the flip-phone clutching luddites have heard of Artificial Intelligence. By the way, I got that 40% statistic from OpenAI's Chat GPT, . Folks, it's no joke, AI is here, and it is poised to grow well into the future.

I have a good friend who is in the food services industry, and just the other night, he was telling me that a medium-but-respectably-sized local restaurant chain is using AI to take orders and that, as a result, sales per call are up by double digits. I know that sounds boring, but… come on, double digits. It's real, and it goes far beyond the shiny mega-cap stocks that most of us associate it with. But here is the thing. Getting AI to work properly takes effort - and investment.

After last night's close, we got earnings releases from two AI heavyweights and Mag-7 members, Meta and Microsoft. The latter was the first to open Wall Street's eyes to the potential of AI, back in the dark days of 2023. After having suffered significant declines in 2022, equity markets were lifted out of the ashes with Microsoft's outing of its relationship with OpenAI. I would argue that its announcement was a key factor in the turnaround which led to the nearly 50% gains in the S&P500 since. To be clear, AI was already around, but let's just say the concept was mainstreamed with Microsoft. OK, so, kudos to them, but we give our hard-earned money to companies with hopes that they will - um, deliver financial returns. In other words, it's not enough to come up with sexy ideas, firms are responsible for making money.

Well, Microsoft did indeed make money with AI. Just look at this chart which shows a breakdown of some of Microsoft's revenues per quarter. Those larger and fast-growing, orange bars are revenues from its Intelligent Cloud business. Most of us use the company's Office products (I am actually writing this on one of them ), and the company does certainly derive significant revenues there as well (yellow bars), but it is eclipsed by the company's Intelligent Cloud revenues. I hope that you also notice how the orange bars are growing at a faster pace than all others. Finally, the bottom on the chart is studded with its more traditional revenue sources (including one of my favorites, LinkedIn). There, you will notice respectable revenues, but with almost no growth. Now, you can see how Microsoft can still be considered a growth company 49 years after Bill Gates and Paul Allen founded the company.

It should be clear that Microsoft did deliver on a core tenet of growth investing. Rather than ride its past successes, now matured, into the sunset, the company found alternative springs of growth, initially in its outsourced computing service (Azure), but ultimately morphed itself into an AI first mover. Remember, we invest in high-valued companies only if they have wild growth prospects for the future. I think, by now, it is safe to say that AI offers those prospects.

Ok, discovering a source of future revenues is one thing, converting it into sales is another, but profitability is still yet another, and that is the Holy Grail, attained by only a scant few. If you did the fancy math on the above chart you would note that quarterly revenues from Intelligent Cloud grew by 140% since Q2 2020 through current. Not shown on this chart was operating income from Intelligent Cloud, which grew by some 95% over the same period. While that is respectable, one should conclude that if revenues grew quicker than operating income, the company's costs have increased over time. It is a new and growing service, and getting it up and running, profitably, requires ramping up investment. Typically, once the business line is established, companies will focus on making them more margin efficient. But this business is still very much in its growth stage. Alas, there is something else.

To have a successful AI service, a massive amount of computing power is required to generate the "I" in AI. That's right, AI needs to learn, and it takes lots of servers, FAST servers, to take in the massive amount of data to make it useful. In other words, Microsoft has to buy lots of servers and build large data centers to support that growth in the chart above. You won't find that in the company's income statement. That is, it is technically not included in the EPS calculation we typically look at in an earnings report. No. You have to dig into my favorite financial statement: The Cash Flow Statement.Interesting side note: the cash flow statement has been my favorite go-to since reading about it in Martin Fridson's "Financial Statement Analysis: A Practitioner's Guide" was assigned to me in my MBA program back in the 1990s. It is one of only three books that I have kept from all my years in finance; I guess, based on that, you should conclude that cash flows are important, but you probably know that my regular readers.

Well, if you do look at Microsoft's cash flows, you find that they have increased expenditures rather steeply in the past 2 years (see the chart at the end of this section). That is almost directly related to the company's expansion in intelligent cloud services. Now, I am not the only guy looking at cash flow statements, haha. Every Wall Street analyst starts with cash flows these days, and those analysts have been critical about Microsoft's growing expenditures. Last night's announcement in which Microsoft beat EPS and Revenue estimates and revealed a 20% Intelligent Cloud revenue increase from the prior quarter, was simply not enough for some. You see, the company's capital spending of almost $15 billion seemed disproportionately large (and increasing) for the growth in revenues. In fact, the company admitted that it was scrambling to build the data infrastructure required to keep up with demand for the AI services.

In this morning's premarket, Microsoft's shares are down by -3.59% for those very reasons. Large capex growth with fears that the company is struggling to keep up. OK! Let's take a step back and think carefully about that. In order for AI to work, one needs servers and infrastructure. IT REQUIRES INVESTMENT. Is that investment worth it? I don't know, is revenue growth of 140% in the past few years, and growing, worth it? I think you know the answer to that. Next question. Is high demand for the services, so much so that the company is scrambling to build infrastructure, a good thing or bad thing? Would you rather invest in a company that is spending money for "hopes" of getting great revenues, or one that is rushing to get products on the shelves as demand skyrockets. I will let you decide. Remember, you are a long-term investor. I just checked Amazon for Fridson's book. You can get a 5th edition for $64; my first edition is priceless. Amazon will announce its earnings after the closing bell, and analysts will be looking very closely at… wait for it… AI, cloud services, and capex. You already knew that.

YESTERDAY'S MARKETS

NEXT UP

  • Personal Income (September) is expected to have grown by +0.3% compared to last month's +0.2%.
  • Personal Spending (September) is expected have increased by +0.4% compared to August's +0.2% growth.
  • PCE Deflator (September) may have slowed to 2.6% from 2.7%.
  • Initial Jobless Claims (October 26th) is expected to come in at 230k, slightly higher than last week's 227k.
  • This morning's earnings: Cinemark, Regeneron, Merck, Uber, Hyatt, Bristol-Myers, Comcast, Peloton, Altria, Norwegian Cruise Lines, Parker-Hannifin, and Mastercard all beat on EPS and Revenues, while Raton, IDEXX Labs, Estee Lauder, Sirius XM, Wendy's, International Paper, and Grainger came up short. After the closing bell, we will hear from US Steel, Intel, VICI Properties, Onto Innovation, Amazon.com, Apple, and Juniper Networks.

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