Integration Of Copilot In 365 Will Accelerate Enterprise Adoption

Key Takeaways

• Rapid growth in AI and strategic partnerships are key drivers of long-term revenue and margin expansion for Microsoft.
  
• Prioritizing high-margin opportunities in gaming and productivity boosts revenue growth and efficiency gains.
  
• Execution challenges and capacity constraints in AI workloads, along with market weaknesses, could hinder Azure, LinkedIn, and gaming segment revenue growth.

Catalysts

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• The rapid growth in Microsoft's AI business, with an annual revenue run rate surpassing $13 billion (up 175% year-over-year), is a significant catalyst. The company is seeing increased enterprise-wide deployments of AI, which should substantially boost future revenues.
  
• Strong expansion in data center capacity, along with hardware and software optimizations (such as leveraging Moore's Law and AI scaling laws), is driving efficiency gains. This is likely to positively impact future net margins by reducing costs associated with AI inference and training.
  
• Microsoft's strategic partnership with OpenAI has resulted in substantial Azure commitments, contributing to commercial bookings growth of 75% in constant currency. This should support long-term revenue growth as these commitments convert to realized revenue.
  
• The growth and integration of Microsoft Copilot in Microsoft 365 are accelerating. New seats and increased usage are expected to drive revenue growth and higher ARPU (average revenue per user) in the Productivity and Business Processes segment.
  
• The company is prioritizing higher-margin opportunities within gaming and content services, evidenced by record revenues in Game Pass and a strategic focus on platform services. This approach is expected to enhance earnings by bolstering margins in the gaming sector.

Microsoft Future Earnings and Revenue Growth

Assumptions

• Analysts are assuming Microsoft's revenue will grow by 13.7% annually over the next 3 years.
• Analysts assume that profit margins will increase from 35.4% today to 36.0% in 3 years time.
• Analysts expect earnings to reach $138.9 billion (and earnings per share of $18.81) by about March 2028, up from $92.8 billion today. However, there is some disagreement amongst the analysts with the more bearish ones expecting earnings as low as $116.1 billion.
• In order for the above numbers to justify the analysts price target, the company would need to trade at a PE ratio of 33.7x on those 2028 earnings, up from 31.7x today. This future PE is greater than the current PE for the US Software industry at 29.5x.
• Analysts expect the number of shares outstanding to remain consistent over the next 3 years.
• To value all of this in today's terms, we will use a discount rate of 7.51%, as per the Simply Wall St company report.

Microsoft Future Earnings Per Share Growth

Risks

• Microsoft reported execution challenges in their scale motions, particularly around balancing customer migrations and AI workloads, which could impact future Azure non-AI revenue growth.
  
• The company is constrained by AI capacity and has been short on power and space, potentially leading to fluctuations in Azure AI service revenue if not addressed adequately.
  
• A slower-than-expected purchasing trend in on-premises server business and transactional purchasing could impact revenue from their server products segment.
  
• LinkedIn's revenue growth was lower than expected due to continued weakness in the hiring market, posing a potential challenge to future revenue growth in this area.
  
• Gaming hardware revenue experienced declines, and Microsoft anticipates these declines will continue, which may affect overall gaming revenue and profit margins.

Valuation

• The analysts have a consensus price target of $506.242 for Microsoft based on their expectations of its future earnings growth, profit margins and other risk factors. However, there is a degree of disagreement amongst analysts, with the most bullish reporting a price target of $650.0, and the most bearish reporting a price target of just $420.0.
• In order for you to agree with the analyst's consensus, you'd need to believe that by 2028, revenues will be $385.3 billion, earnings will come to $138.9 billion, and it would be trading on a PE ratio of 33.7x, assuming you use a discount rate of 7.5%.
• Given the current share price of $395.16, the analyst price target of $506.24 is 21.9% higher.
• We always encourage you to reach your own conclusions though. So sense check these analyst numbers against your own assumptions and expectations based on your understanding of the business and what you believe is probable.