August 15, 2024. In the current tech company earnings season, a pressing concern in the investment community is that AI related applications may be exacting more capital investment than is justified by their usefulness and profitability to businesses.

Businesses are beginning to depend on AI. But indeed it may not be possible to clearly foresee the many ways it will actually be used, even as it becomes integrated into daily business functions.  And this normal uncertainty, arouses concern, given the very high level of investment required to build the computation resources required for AI.  The investment community has become concerned that AI related capital investment may strain the corporate balance sheet, reducing cash flow and increasing debt. 

One of the core traits of MSFT culture of operations is that it seeks to adapt and exploit its competitive advantage in a profitable way. The company has never commoditized its products and has avoided being vulnerable to the boom/bust cycle of some tech hardware companies. It has a differentiation strategy and strong competitive advantages of switching costs, largely based on software application usage and platforms.

In the webcast of its 4th Quarter of 2024 Earnings, Microsoft CEO Satya Nadella and CFO Amy Hood explicitly articulated that they are conservative in spending on building infrastructure needed for AI workloads, and that in fact demand by their customers for AI computation is outstripping the company’s ability to supply the computing infrastructure.  The deficit in available AI computation is partly relieved by leasing datacenters from companies which maintain large datacenter assets such as Oracle. These have the advantage of being relatively short term leases, purportedly until Microsoft can establish its own new datacenters, and this helps avoid overinvesting.

CEO Nadella emphasized, as one of two corporate goals in navigating the platform shift of AI, that they are using “customer demand signal and time to value to manage our cost structure dynamically and generate durable, long-term operating leverage. “

(The first strategic goal was, no surprise, driving innovation in infrastructure and applications products, while continuing to scale the cloud business, and prioritizing security.)

As per Nadella, AI was central in MSFT progress this quarter. Azure share gains were driven by AI.  Azure growth included 8 points from AI services where demand remained higher than their available capacity.

Despite the incipient growth of the AI business, cloud margins remain extremely strong.  As CFO Amy Hood stated, Microsoft Cloud gross margin declined from 72% to a still excellent 69%, driven by sales mix shift to Azure, partially offset by improvement in Azure even with the impact of scaling AI infrastructure. Microsoft Cloud includes Azure and other cloud services, Office 365 Commercial, the commercial portion of LinkedIn, Dynamics 365 and other cloud properties.

To get a high level view of the ability of Microsoft to lay out Capital Expenditure (Capex) needed to grow its business, including AI, we can compare the growth of capex, net income,  free cash flow (FCF), and revenue, over say, a decade. 

Based on review of the relevant Annual Reports, in the decade from 2015 to 2024, Revenue increased 2.6X from  $93.580B to $245.122B.  Net income to common shares rose 7.2X from $12.193B to $88.136B, as operating and nonoperating expenses rose less than income.  Capex rose 7.5X from $5.944B to $44.477B.  Capex accelerated throughout the decade, and ramped up sharply in 2024.  Of the rise in capex between 2024 and 2015, 42% of this rise took place in 2024 relative to 2023.

Microsoft businesses generate enough cash to fund Capex needs and more.  Even with accelerating Capex, Free Cash Flow (FCF) still increased 3.1X from $23.724B to $74.071B. IN 2024, debt interest coverage is still over 20x, and Debt/Equity ratio at end of 2024 was at the lowest level in the decade. 

Remember that FCF is primarily cash remaining after capex expenditure has been subtracted from the cash flow from operations.

Therefore, Microsoft has shown it can generate the cash required to supply capex to adapt and grow its business as cloud computing and AI shape its markets.  Given its historical record extending back decades, I think it is safe to assume it will continue to do so.

The company outlook forecast for 2025 capex was that it would be larger than 2024.  Let’s hypothetically assume capex doubles from the 2024 level of $44.477 billion to $88.954B (note that annual doubling of capex is unprecedented in the history of Microsoft). Given that operating cash flow has increased at an average annual rate of 14.47% for past decade. Assuming operating cash flow in 2025 increases at this same rate over that of 2024, making $135.144 billion. Then hypothetically FCF in 2025 would be $135.144B – capex of $88.954B = $46.190B.  This is a significant decrease from the 2024 level of FCF, of $74.071B.

Should the company be faced with persistent jumps in Capex requirements, we might be concerned to estimate when the resulting datacenters will produce revenue to maintain cash flow at its accustomed growth level. In this, we can look to clues which the leadership team gave at the earnings conference. 

Just taking two instances of AI related products, we see signs of AI-induced growth in usage and revenue which are promising.

Copilot for Microsoft 365.

Copilot for Microsoft 365 is becoming a daily habit for knowledge workers as it transforms workflow.  The number of people who use Copilot daily at work nearly doubled quarter-over-quarter, as they use it to complete tasks faster, hold more effective meetings, and automate business workflows and processes.  Copilot customers increased more than 60% quarter-over-quarter.

Feedback has been positive, with majority of enterprise customers coming back to purchase more seats.  The number of customers with more than 10,000 seats more than doubled quarter-over-quarter. 

With Copilot Studio, customers can extend Copilot for Microsoft 365 and build custom copilots that proactively respond to data and events using their own first and third-party business data.  To date, 50,000 organizations – from Carnival Corp., Cognizant, and Eaton, to KPMG, Majesco, and McKinsey – have used Copilot Studio, up over 70% quarter-over-quarter.

 Copilot is being extended to specific verticals, including healthcare, with DAX Copilot.  More than 400 healthcare organizations – including Community Health Network, Intermountain, Northwestern Memorial Healthcare, and Ohio State University Wexner Medical Center – have purchased DAX Copilot to date, up over 40% quarter-over-quarter.

Github copilot

GitHub Copilot is by far the most widely adopted AI-powered developer tool.

Just over two years since its general availability, more than 77,000 organizations – from BBVA, FedEx, and H&M, to Infosys and Paytm – have adopted Copilot, up 180% year-over-year. “Copilot accounted for over 40% of GitHub’s revenue growth this year, and is already a larger business than all of GitHub was when we acquired it. “.  I assume that means revenue from Github Copilot is larger than Github revenue was, when acquired by Microsoft for $7.5B in 2018.  And Github has a current annual revenue run rate of $2B.  So, not only is its usage growing, but this has been turbocharged by Copilot AI.

In summary, based on review of relevant past financial disclosures including Annual Reports, the Q4 2024 earnings conference, and understanding of Microsoft business culture as it has operated historically, Microsoft should be able to continue to spend as required for Capex to build out AI and cloud computation.  Growth in usage of AI-related products should lead to continued earnings growth. Most importantly, over the long run, the novel AI-related features will become indispensable tools for knowledge workers and will confer the strong competitive advantages of switching costs which enable Microsoft to keep dominating its markets.