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Why Microsoft Leads the AI Race

The tech giant’s alliance with ChatGPT’s maker positions it to dominate the early AI market, says Morningstar – and competitors face a wide moat.

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Microsoft (Bigstock photo)

“We are finally entering the AI age,” stated a Morningstar report published in May. “AI has been in development for years, but OpenAI’s ChatGPT has crystallized potential use cases for consumers.” Indeed, while various tech applications and websites have used aspects of artificial intelligence for at least a decade, countless people only now being jolted awake to the thrilling possibilities – and risks – that AI holds for humanity.

If you’re one of them, this wake-up probably came courtesy of a specific experience: typing questions into ChatGPT, an app launched in late 2022 by the company OpenAI. Maybe you tried it as a lark, but its humanlike responses soon made it clear that this technology and its brethren are going to change our lives, if exactly how and when remain uncertain.

“OpenAI’s ChatGPT has captured the attention of CEOs, software engineers, as well as the general public and has emerged as the quickest technology service to gain its first 1 million users, which took just five days, according to Sam Altman, OpenAI founder and CEO,” wrote the report’s authors, Dan Romanoff, CPA, Senior Equity Research Analyst at Morningstar, and Jack Keegan, Associate Equity Research Analyst at the company.

Investors have also noticed. While many have long known that wielding significant influence in AI could radically change the fortunes of tech companies across the world, throngs now believe such disruption could be coming within year or two rather than a decade. Naturally, the companies that work with generative AI – which is utilized by ChatGPT – are getting scrutinized by investors and analysts zealously trying to foresee which organizations could gain an edge in a market that, even while obscured by hype, shows tantalizing promise.

A familiar name leads the pack

Generative AI has ample potential to create several rags-to-riches stories among young and unknown companies in the next years. But in mid-2023 – and likely through the mid-2020s, although nothing’s certain – investors can look to a familiar name to capture early market gains and make the headline-worthy advancements. The Morningstar report, entitled “Microsoft Emerges as Early Leader in the Artificial Intelligence Race,” emphasizes this aspect of the industry and discusses why Microsoft is poised to dominate the AI industry over the next several years and see enviable growth as a result.

OpenAI’s ChatGPT – not coincidentally – is the pivotal weapon in the computing giant’s AI arsenal. While several companies have struck agreements with OpenAI to use their ground-breaking generative AI technology in their products and applications, Microsoft’s partnership is the most prominent and, perhaps, the alliance that’s most likely to influence the AI market.

Microsoft has reportedly committed to invest $10 billion in OpenAI over a multi-year period (a relatively small expense for the Seattle juggernaut). “Details were not disclosed,” the Morningstar report states, but the deal “is widely believed to be $10 billion for 49% of [ownership in OpenAI],” plus 75% of the OpenAI’s profits until it’s $10 billion investment is repaid. The report authors add:

We think this [partnership] has immediately lifted Microsoft to be one of the prime beneficiaries of the AI boom, with early access to OpenAI’s models and an ability to commercialize the previous generation’s models, and the attachment to OpenAI through Azure. We already see Microsoft releasing OpenAI-based advanced AI throughout its portfolio, including Microsoft 365, GitHub, and Bing, where we think the company can make the biggest splash.

Combining the world’s most popular productivity software in Microsoft 365 with the world’s most advanced foundational AI models in GPT-4 should create a powerful force within the software industry. We think Microsoft immediately becomes among the best-positioned software company to lead into the golden age of AI. While we think this opens up another competitive vector against Alphabet and other AI providers; we think Microsoft’s investments in OpenAI and related technology provide an early lead.

How will AI impact Microsoft’s growth?

Morningstar – which believes Microsoft is modestly undervalued even without factoring in its leadership position in AI – cautions investors that the financial impact from its valuable partnership with OpenAI maker is likely to be incremental, though certainly significantly.

More specifically, Morningstar’s analysts say the synergy from this union 1) has added about $22 to their fair estimated value of Microsoft’s share price, bringing it to $345 (it’s trading near $330 in mid-June 2023) – and 2) will add 50-100 basis points to Microsoft’s annual revenue growth over the next decade.

Indeed, OpenAI has had a meteoric rise. With a revenue of just $50 million in 2022, the company expects to reach $200 million in 2023 and $1 billion in 2024, according to the Morningstar report. But the true financial benefits to Microsoft will likely come through implementing OpenAI’s technology throughout its products. “Given the immense potential for productivity improvements [due to the use of advanced generative AI],” the report states:

…we can envision an upside scenario that is 5%-10% above our fair value estimate [of $325 per share], thanks to higher AI-bolstered revenue growth. Still, we caution investors on the AI hype for Microsoft as the company’s immense size makes it difficult for any new product to dramatically move the needle on valuation, in our view.

…On a financial basis, our initial estimate is that OpenAI can boost Microsoft’s revenue growth by 50-100 basis points annually over the next five to 10 years; this should not put material pressure on margins and can add in excess of $20 to our fair value estimate.

…Over the next few years, we believe generative AI adoption within Microsoft 365 can add billions of dollars to Microsoft’s annual revenue. Depending on the pricing uplift and product bundling, it is not a stretch to see $2 billion-$3 billion in incremental revenue within a couple years.

The below charts from the Morningstar report show its analysts’ estimations and forecasts for (chart 1) the incremental growth Microsoft could realize due to generative AI over the next decade, (chart 2) the growth in Microsoft’s share price due to adding AI to specific products, and (chart 3) the size and growth of the software AI through 2027.

Chart 1: Morningstar believes advanced generative AI can drive incremental revenue growth of 50-100 basis points annually.

Chart 2: Morningstar believes Microsoft’s use of advanced generative AI in its leading products “can add $22 of potential upside to our fair value estimate [of $325 for its share price]…assuming stable free cash flow margins in the low 30% area.”

Chart 3: Morningstar sees a sizeable market with significant growth potential for AI software (just one niche in AI) in the coming years.

Competitors are coming, but…

Tech companies across the globe, small and large, are racing to develop products that use advanced AI. However, tapping the power of the large language models (LLMs) and neural networks that drive the newest AI technology is an expensive endeavor – costing billions in specialized employees, hardware, and infrastructure. Striking partnerships with cutting-edge entities (such as Microsoft has done with OpenAI) will be a necessity for many companies to offer their users AI capabilities.

Further, refusing to play probably won’t be an option. As Morningstar mentions in its report, any company with a software application to sell will soon need to showcase advanced AI in that app just to survive. “We think AI will quickly become table stakes within enterprise software applications and internet usage, the report notes. “Additionally, there is the ‘me too’ factor whereby no software company wants to be the one firm that cannot tout AI as a feature within its application or across its portfolio.”

Again, all these factors bode well for Microsoft’s position as the AI leader – even if this market is in its infancy and will see rapid evolution. Microsoft’s vast scale and financial resources, deeply embedded use in both industry and consumer technologies, and ability to capitalize on OpenAI’s momentum and innovations are combining to form a daunting barrier to competitors (even other behemoths like Apple and Alphabet) that seek to grow in the AI space. According to Morningstar:

Microsoft enjoys a wide moat rating, in our view, arising from switching costs, network effects, and cost advantages. We believe each of the company’s segments benefits from both switching costs and network effects, while the Intelligent Cloud segment also carries cost advantages. In aggregate, these moat sources should combine to drive economic returns well in excess of its cost of capital for years to come.

Learn more about investment opportunities in advanced AI.

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