Goldman Sachs recently reiterated its Buy rating on Microsoft, setting a price target of $515 in a note this week. The investment bank pointed to the strong returns from Microsoft’s investments in generative AI (Gen-AI). Although some investors have raised concerns about the return on investment for Gen-AI, Goldman Sachs drew parallels with Microsoft’s successful development of Azure cloud computing.
The analysts at Goldman Sachs highlighted that Microsoft’s Gen-AI has already achieved a level of CapEx efficiency comparable to years four or five of the cloud computing cycle, even though Gen-AI is only about a year into its launch. This shows a promising trajectory for the company. Microsoft has managed to balance the rapid growth in Capital Expenditure (CapEx) with tangible AI revenue generation.
Despite the fact that AI revenue is currently generating positive gross profits, depreciation exceeds revenue, leading to a dilution in gross margins. The analysts estimated that without these investments, Microsoft’s gross margins could have been higher by 150 to 300 basis points. However, they also noted that AI-specific gross profits in FY24 are already comparable to what Azure achieved eight years after its launch in FY2018.
The analysts at Goldman Sachs also pointed out that Microsoft’s operating margin (OM) has increased by 10 percentage points since Azure began contributing significantly to revenue in FY12/13, despite a 7 percentage point contraction in gross margins. They foresee a similar trajectory for Gen-AI, with AI revenue growing faster than Azure. After just one year, AI-driven revenue is already equivalent to what Azure achieved in year seven.
Looking ahead, the analysts believe that margins will eventually benefit from greater scale, leading to slower growth in CapEx and improved margins. They also expect Microsoft to reach a critical mass for Gen-AI much faster than it did for Azure, which took seven years to achieve similar milestones.
Overall, Goldman Sachs remains optimistic about Microsoft’s prospects, citing the promising returns from its investments in generative AI. The analysts see parallels between the development of Gen-AI and the successful growth of Azure cloud computing, which bodes well for the company’s future profitability and growth potential.
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