Azure-Ads-AI: Microsoft’s Triple-A Growth Strategy (NASDAQ: MSFT)

Over the months, artificial intelligence has once again become a buzzword with the emergence of public AI chatbots like the OpenAI chatbot. Besides the widespread fear over the business model of search engines like Alphabet (GOOG, GOOGL) Google to be disturbed (my opinion on the subject), a company was targeted: Microsoft (NASDAQ: MSFT) was one of top OpenAI backers since July 2019, where the company invested $1 billion to support the creation of artificial general intelligence (AGI) with widely distributed economic benefits and provided the required computing power on its Azure Cloud platform. Now, Microsoft is looking to reap the benefits of this technology and has talked a lot about it. In this article, I will talk about Microsoft’s triple A growth strategy.

What does triple-A mean in this context?

Triple-A in the context of Microsoft has two meanings:

• First, Microsoft’s credit rating is AAA by S&P Global (SPGI) and Aaa by Moody’s (MCO), the best possible ratings given only to Microsoft and Johnson & Johnson (JNJ). This showcases the company’s incredible financial strength and sustainability.
• The second AAA is, as mentioned in the title, Azure-Ads-AI. It’s Microsoft’s growth engine for this decade, as Windows and Office are, though still growing, already at gigantic size and the market leader. This article will focus on the combination of these three segments and how they can propel Microsoft forward.

Break down the different parts

Microsoft is one of the largest companies in the world and one of the most covered companies. Yet I think the advertising opportunity is underestimated and AI has only just come back into the limelight.

Azure blue

I won’t discuss Azure in detail here as it is a well-known part of the business. In short, Azure is the fastest growing business group within Microsoft and home to the cloud computing business. Over the past 12 quarters, growth has steadily slowed from 59% to 40%, but at an annual revenue rate of over $67 billion, it’s still incredibly fast growth.

Advertising

According to Research and Markets, the global digital advertising and marketing market is expected to continue its rapid growth of 13.9% per year through 2026, when it is expected to reach $786 billion. If you think of digital ads, the first companies that come to mind are Google, Facebook (META) and maybe Amazon (AMZN), but most people probably don’t think of Microsoft. Still, the company generates over $10 billion from ads, taking a small market share of this huge pie. Microsoft’s advertising business consists of three parts:

• Bing Announcements and News
• LinkedIn Ads
• Xandr platform

Bing is the second largest search engine in the world, with a tiny market share of around 3% compared to the behemoth that is Google Search. Despite its small size, Microsoft managed to generate $11.6 billion in revenue through 2022 with Bing Ads and News, a personalized news feed. Microsoft is pushing its Edge browser (4% market share) and Bing to all Windows computers, which is probably a big chunk of the market share because right now Google is arguably the best search engine.

LinkedIn is the world’s largest social network for professionals, with more than 875 million professionals and 61 million businesses using the service. LinkedIn’s revenue consists of premium subscriptions (between $30 and $100 per month per account) and advertising on the site and throughout Microsoft’s advertising network.

Xandr is a recently acquired online platform for buying and selling consumer-centric digital advertising. Last year, Microsoft announced that it would be the provider of Netflix’s ad-supported subscription tier (NFLX). It is speculated that this deal could net Netflix billions of dollars in revenue. If the Netflix Ad level is successful, it could be used as a case study for Microsoft to get more deals in the space, especially in the connected TV and video space.

Artificial intelligence

I’ve already mentioned Microsoft’s initial investment in OpenAI. Yesterday’s news broke that the company plans to invest $10 billion to buy a significant stake in OpenAI, valuing the company at $29 billion. Microsoft would get 75% of future earnings from OpenAI until it recoups the $10 billion, after which the company would retain a 49% stake in OpenAI. According to a news article, Microsoft is looking to add OpenAIs chatbot technology to Word, Outlook and other Office solutions. The company also announced the integration of ChatGPT and DALL-E 2, the OpenAIs image generator, into Bing. Microsoft is clearly looking to leverage OpenAI’s capabilities to improve its own products in the office and advertising spaces. This could further strengthen the market leadership of its office products and help Bing capture more market share. Overall, I like the risk/reward ratio of this integration for Microsoft. The future of AI is exciting and Microsoft could be a key player in this.

Microsoft is a buy

Let’s value Microsoft based on multiple and inverse DCF methods.

I usually use the ten-year median multiples, but with Microsoft I think a shorter time frame is needed because the company has completely transformed over the past decade with subscriptions and cloud computing. We can see that Microsoft was incredibly expensive in 2020 and 2021, trading around 35 PE and 25 EV/EBITDA. Now the valuation has fallen considerably below its median. A similar picture can be seen if we look at the FCF yield, which is now slightly above the median (remember we are looking at a yield, so the higher the better).

For my inverse DCF model, I always use a discount rate/required rate of return of 10%, a perpetual growth rate of 3%, and an assumed reduction of 1% in outstanding shares each year due to buybacks. Microsoft shares, which more than offset the dilution of stock-based earnings. Microsoft doesn’t typically dilute to acquire businesses due to its huge cash flow, so there’s no need to consider dilution on that side either. With these assumptions, Microsoft’s price implies a 9% growth rate over the first five years, followed by 8% growth over the next five years, a considerable deceleration from its 18% CAGR of FCF per share over five years. I don’t expect Microsoft to hit 18%, but I think a low double-digit growth rate in FCF per share seems very likely.

To conclude, Microsoft has many opportunities ahead of it in the advertising market and improving its products with AI capabilities to stay competitive and gain more market share. Microsoft is currently the largest position in my equity portfolio, with an allocation of around 13%.