Artificial intelligence (AI) burst onto the scene last year, making headlines and sparking public interest. While the technology has been around in some form or another since the 1950s, recent advances have produced models that can create original content and streamline processes, resulting in dramatic productivity gains. This has captured the attention of Main Street and Wall Street alike.
Veteran Wedbush tech analyst Dan Ives said generative AI could spark the "fourth industrial revolution," adding "AI is the most transformational technology we have seen since the internet started to take shape."
That's a bold view but one that's spreading through tech like wildfire. Even the most conservative estimates suggest that generative AI could generate more than $1 trillion in incremental spending over the coming decade. Companies positioned to profit from this paradigm shift will capture part of the windfall, enriching shareholders along the way.
My portfolio is rich with AI stocks, but the one I'm most excited about right now is Microsoft (MSFT -3.21%).
Image source: Getty Images.
The once and future king
Earlier branches of AI have been used extensively in the tech industry for decades. Recommendations made by streaming services and online retailers, voice and facial recognition on smartphones, and maps and navigation software are just a few of a multitude of ways AI is already enriching our lives.
The coming of generative AI takes that to the next level. Generative AI can create original text and music, summarize data, draft email responses, create presentations from existing data, and even write and debug computer code. Novel uses for the technology are being developed every day.
Microsoft recognized the utility of generative AI early on, investing $1 billion in ChatGPT creator OpenAI as early as 2019, increasing its stake to $13 billion last year. The company quickly integrated this technology into many of its flagship products, imbuing them with AI functionality, resulting in increased productivity for users. Generative AI also has the potential to generate billions of dollars in incremental revenue for Microsoft.
Perhaps the greatest potential lies with Copilot, Microsoft's AI-powered digital assistant, variations of which are deeply integrated into the company's most popular software-as-a-service (SaaS) products. The ability of Copilot to streamline mundane and time-consuming tasks is getting rave reviews from Microsoft customers. The company recently revealed that 40% of Fortune 100 companies had tested the product as part of its early-access program, and Copilot has since been made available for general release. In an interview in mid-2023, CFO Amy Hood said, "The next-generation AI business will be the fastest-growing $10 billion business in our history."
Given the extent of Microsoft's customer base, the market potential for Copilot and similar AI tools could be extremely lucrative. The company has thus far been mum, but Wall Street is weighing in with estimates. Dan Loeb, founder of hedge fund Third Point, suggests the tech could generate "$25 billion or more in software sales alone." Estimates from Evercore ISI analyst Kirk Materne are even more eye-catching, as he calculates that generative AI could add more than $100 billion to Microsoft's coffers by 2027.
Azure is aiming for the title
With businesses of all sizes clamoring to benefit from AI, the big three cloud-infrastructure providers represent the best avenue to bring this technology to the masses and profit along the way. Amazon Web Services (AWS) has long been the leader in the industry it pioneered, but Azure is gunning for the title.
In Microsoft's fiscal 2024 first quarter (ended Sep. 30), Azure Cloud gained market share at the expense of its rivals. Microsoft's cloud revenue climbed 29% year over year, outpacing both Alphabet's Google Cloud and AWS, which grew 22% and 12%, respectively. The reason? Microsoft said "roughly three points" of Azure's growth was the result of strong demand for AI.
In calendar Q3, AWS, Azure, and Google Cloud controlled 31%, 25%, and 10%, respectively, of worldwide cloud-infrastructure spending, according to research firm Canalys. If Microsoft can continue to gain ground on its rivals, it could eventually steal the cloud crown from Amazon.
There's likely more to come
CEO Satya Nadella said in 2016 that "AI is at the intersection of [Microsoft's] ambitions." Taking the long view and being prepared for the advent of AI has served the company well, but there are other drivers that could push Microsoft higher.
The company's more personal computing segment is a prime example. The downturn crushed demand for PCs as consumers and businesses cut back to weather the economic storm. The segment, which previously accounted for nearly one-third of Microsoft's revenue, was hit hard. However, PC shipments are expected to climb 8% in 2024, according to Canalys, which could help fuel additional growth. Furthermore, if Microsoft continues to steal cloud market share, that would also be a boon to the company.
Despite notching gains of over 60% over the past year, Microsoft's valuation is still fairly reasonable, selling for 35 times forward earnings and 12 times forward sales. While that represents a slight premium to the overall market, the magnitude of the opportunity within its grasp shows why it's deserving of a premium.
