Key Points
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Nadella turned around Microsoft by focusing on enterprise cloud solutions in both software and compute.
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Microsoft Azure, its cloud computing platform, has become a major growth driver in recent years.
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Is AI a threat or an opportunity for Microsoft?
- 10 stocks we like better than Microsoft ›
Bill Gates handed over the reins of Microsoft (NASDAQ: MSFT) to Steve Ballmer in early 2000. Gates had built the software business into the world’s largest company by market cap, perhaps with a little help from dot-com stock enthusiasm.
To be sure, Ballmer took over the company in a precarious position. Not only were tech stock valuations extremely frothy, but Microsoft was also fighting its antitrust lawsuit. The stock dropped more than 70% as the dot-com bubble popped, but Ballmer never recovered the company’s old highs.
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The 2008 financial crisis took another bite out of the stock. And while it recovered somewhat with the rest of the market in the early 2010s, Microsoft’s stock price was still down more than 32% from when Ballmer took over to when he departed.
His successor and current Microsoft CEO, Satya Nadella, has had much greater success. The stock has risen more than 14-fold since he took over, producing an annualized return for shareholders exceeding 23%.
Nadella has transformed Microsoft into a cloud computing business across both its enterprise software and Azure cloud platform. The latter is now driving significant overall growth, fueled by AI investments. Microsoft is spending heavily to keep up with demand, and some investors may be wondering whether it can continue to grow its value by around 20% annually after such a tremendous run.
Microsoft CEO Satya Nadella. Image source: Microsoft Corp.
Can Microsoft stock keep climbing from here?
Microsoft’s stock has been under pressure over the past year since the share price peaked in October. While it’s mostly recovered from a drop of 35% at one point, the stock still trades about 5% below its all-time high. The drop in the stock price is due to fears regarding artificial intelligence (AI).
AI could impact Microsoft in two ways. First, its enterprise software business, anchored by its Microsoft 365 suite, could be disrupted by AI. Many argue that AI-developed software could displace much of the functionality of, and the need for, existing software solutions. The second way is that Microsoft is spending hundreds of billions to build out AI data centers, pushing its free cash flow lower.
The first situation is unlikely to have a real impact on Microsoft’s software business. Microsoft’s suite is a workplace standard. An enterprise moving away from it would incur significant switching costs and interoperability challenges that are probably not worth any cost savings on the software itself.
The second challenge is more real, but the risks may be overblown. Microsoft is investing in AI compute capacity with highly predictable returns on investment thanks to long-term contracts with several customers. Microsoft ended last quarter with $678 billion in contracted revenue across Azure and its software business.
The risk that it will spend too much on compute is unlikely to materialize, especially given that Microsoft uses Azure compute capacity for its own AI development. Further mitigating that risk is management’s commitment to maintain positive free cash flow.
Over the long run, Microsoft should be a net beneficiary of increased spending on AI for both compute used by developers and software used by enterprises. That should lead to sustained earnings growth around that 20% target rate. If Microsoft maintains its earnings multiple, the stock will climb at the same pace. That’s not quite as fast as the first 12 years of Nadella’s tenure, but it’s close enough to make it a great investment.
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Adam Levy has positions in Microsoft. The Motley Fool has positions in and recommends Microsoft. The Motley Fool has a disclosure policy.
