Microsoft, OpenAI, and Cloud Computing – News or Noise?

Altman and AI

Over the past week, the news surrounding OpenAI and the aftermath of CEO Sam Altman's dismissal and subsequent re-hiring have been hard to ignore. Developments seemed to unfold rapidly, and the current state of affairs, with Altman's return and a new board, raises questions about whether it will provide OpenAI with the stability needed moving forward.

As investors, we at ELMRI maintain a substantial position in Microsoft (MSFT) and have been closely following the OpenAI saga from this perspective. Notably, Microsoft holds a 49% stake in its for-profit subsidiary, OpenAI Global, and is its largest client, using the ChatGPT model as the foundation for Microsoft's own AI products. Initially posing a potential risk to Microsoft, CEO Satya Nadella skillfully diffused the situation by swiftly rehiring Altman and offering positions to disgruntled OpenAI employees in a dedicated AI division. This not only ensured the uninterrupted rollout of Microsoft's AI tools and integrations but also exerted maximum pressure on OpenAI's board, facing the potential loss of both their CEO and the majority of their human capital.

It has also come to light that OpenAI has received only a fraction of the approximately $13 billion that Microsoft planned to invest. The funding is not only divided into tranches but also includes a substantial portion in the form of the purchase of cloud computing services utilizing Microsoft's infrastructure. Consequently, Microsoft's exposure in the event of an OpenAI collapse may not be as significant as initially perceived.

Amidst these swirling events, it's easy to be swayed by the fluctuating narrative from dire to optimistic. However, my core philosophy as a portfolio manager is to focus on key value drivers for long-term growth, evaluating whether news events genuinely impact those underlying fundamentals. To comprehend these issues fully, a broader context and more information are essential.

Cloud Computing: Microsoft, Amazon, and Alphabet

Adopting a longer-term perspective, it's hard to believe that just twelve months ago, OpenAI launched ChatGPT, igniting the current surge of public interest and innovation in AI. This has resulted in rapid growth not only in AI software and services but, more crucially, in AI integrations into existing products. Consider how many programs you use daily that now boast a 'magic' button or 'smart' assistant.

Behind the scenes, due to the massive data processing demands of AI models, all these services operate 'in the cloud,' leading to increased demand and requirements for companies providing the infrastructure and services for Cloud Computing — the remote storage and access of files and software.

The three major providers of these services, known as 'hyperscalers,' are Amazon, Microsoft, and Alphabet (Google's parent). Their existing mega-cap global status, driven by primary services like ecommerce, productivity software, and search advertising, has allowed them to rapidly develop the massive infrastructure needed to support their cloud computing offerings. For each, their cloud computing business is the fastest-growing arm of their company, making it particularly interesting for investors.

In October, all three companies released their quarterly reports, yielding mixed results. Amazon, the most established in the space, holds the largest market share, but its growth rate has dropped to 12%. Microsoft's report was positive, with a growth rate increasing from 26% to 29%, and an impressive profit margin of about 40%. Google, with the smallest market share, boasts a good growth rate of 22%, but a less favourable profit margin of about 3%, making it the least profitable.

Returning to front-end AI offerings, Microsoft has clearly outlined its plans to integrate AI into Office and Azure services, providing an additional pathway to monetization in this field.

News or Noise?

In summary, we believe that Microsoft is well-positioned regardless of the outcome of the OpenAI situation. They stand to profit from the rise of AI both on the back-end (through cloud computing infrastructure) and front-end (through integration into their software). While they undoubtedly hope for a stable continuation of their working relationship with OpenAI, their leadership has demonstrated the ability to navigate uncertain situations, auguring well for continued growth in the coming decade.