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The Intrinsic Value Podcast - The Investor’s Podcast Network
TIVP070 (Video): Microsoft (MSFT): Is Microsoft a Misunderstood AI Opportunity? w/ Shawn O'Malley & Daniel Mahncke
01:32:59
Join Daniel and Shawn as they work through whether Microsoft's software moats can survive the very technology Microsoft is helping to build.
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- [00:01]
Daniel Munga
Microsoft is without a doubt still one of the highest mode businesses in the world, but I would still say that it's in a very critical transition phase that it has to nail. Now.
- [00:11]
Sean O'Malley
You're not used to seeing the market doubt Microsoft the way it currently is. Usually this is one of the most stable Mag 7 companies out there, but
- [00:22]
Daniel Munga
that's also where it might be a rare opportunity to buy Microsoft at historically low multiples today. So we did that with Google and it was our most successful investment last year. And today we will see if Microsoft can become our most successful investment this year.
- [00:39]
Podcast Host/Announcer
You're listening to the Intrinsic Value Podcast by the Investors podcast network. Since 2014, with over 180 million downloads, we've learned directly from the world's best investors. Now we're applying those lessons to analyze businesses and investment opportunities every week, helping you uncover intrinsic value. This show is not investment advice. It's intended for informational and entertainment purposes only. All opinions expressed by hosts and guests are solely their own and they may have investments in the securities discussed. And now, here are your hosts, Sean o' Malley and Daniel Munka.
- [01:23]
Sean O'Malley
Before we get started, a quick heads up for our listeners. The Intrinsic Value Podcast is now being jointly published on the Investors Podcast Feed, formerly known as We Study Billionaires. If you are hearing this on the Intrinsic Value Podcast feed, nothing changes for you. You will keep getting every episode right here. But if you want early access to our episodes and company coverage alongside the full lineup of content from the Investors Podcast Network, you can find us on the new feed as well. So we've included a direct link in the episode description or or you can simply search the Investors Podcast in your podcast app and hit subscribe. Same deep dives, same stock breakdowns, just a bigger home. Thank you for listening and let's get into today's episode. For long term investors, the current market in some ways might look like a gift because you have some great companies that have sold off to attractive prices. And today we are talking about a company that has dominated the last 30 years of American tech like few others. And despite what have looked like very solid numbers from this company in the last quarter, the stock sold off 35% in the last six months. So that's exactly what I'm talking about. And that means Microsoft, the company of interest today, is now trading at a forward PE of just 20 times earnings.
- [02:56]
Daniel Munga
And mind you that just six months ago, investors were still willing to pay 40 times earnings for this company. And it's even more interesting if you compare how Google and Microsoft have performed since ChatGPT came out, because I still remember that, you know, ChatGPT was supposed to be the end of Google. And Microsoft, through owning a stake in OpenAI, was kind of seen as the big AI winner among the Max 7. And then now fast forward a little more than three years and Google is up 200% and Microsoft is kind of trailing Google significantly.
- [03:27]
Sean O'Malley
Yeah. Looking at the stock charts, it's kind of surprising to me that Microsoft stock has never really benefited from the hype around ChatGPT. I mean, there are very few times in the last three years when it outperformed Google comparatively. Right.
- [03:41]
Daniel Munga
It is a bit surprising, although it also depends on when you start the comparison. I mean, if we look at the chart Starting in late 2022, it doesn't look like any significant outperformance, but if we start from early 2022, things look quite different. So essentially what you would see is that Microsoft, thanks to its stake in OpenAI, recovered significantly faster from this big tech drawdown that I think we've all still remember in 2022. And then the underperformance really only started a couple of months ago when, you know, Google started rallying. And everybody is thinking of Google as like the big AI winner. And then Microsoft and OpenAI kind of got into the backseat.
- [04:17]
Sean O'Malley
Yeah, I mean, it makes sense because Microsoft was definitely at a time seen as the biggest winner of the AI revolution, really, generally in the markets, but especially among the Mag 7. But before we lose ourselves on a Google tangent, how about you just quickly give an introduction into why the Microsoft stock has performed so poorly in recent months, and then we can go into the details of the business and assess whether we think the market is wrong or right about Microsoft.
- [04:44]
Daniel Munga
I mean, generally, Microsoft as well AS also some SaaS companies have recovered a little bit in the last couple of weeks, but still, I mean, if you compare it to Google, it is certainly crazy to see how the narrative shifted and also how quickly that happened. So to sort of frame the episode today, I would say that today's goal is to figure out whether Microsoft now is in a similar position to Alphabet back in early 2025. It's a great business, and it has been a great business at that point, but I think it was temporarily kind of misunderstood by the market. And that's also why we wanted to buy the stock back then. And since then, it has performed incredibly well for us. So we kind of did what all value investors would do. And yeah, I think those are the situations we look for. And, you know, when I Saw some tweets about Microsoft and also the general multiples it's trading at. I felt like it has to be a company that we cover. And by the way, we just came back from Omaha, and it just came to my mind because I got a couple of questions on Microsoft AI and also SaaS in general when I was there, and I just wanted to take the opportunity and thank everyone who made it to our little conference. I think it was a fantastic experience. We met so many of you, and we were also able to exchange ideas and opinions on the market. And it's just incredible how Omaha feels like this place, maybe the only place on earth where you can talk about stocks and investing for many, many hours without boring anyone. And, I don't know, it just gives me a whole lot of energy.
- [06:07]
Sean O'Malley
Oh, absolutely. I mean, we're not even halfway through 2026, and I think it's pretty safe to say that Omaha was once again, one of the biggest highlights of the year already. And after this conference, I'm pretty confident we should make it even bigger next year. I don't know what you think, Daniel, but maybe we should really scale this thing up. More stock pitches, more opportunities to connect and ask questions. And, you know, whenever you do a conference for the first time, you're not sure how things are going to turn out. But I think for both of us, I can say that it really exceeded our expectations, and we're really excited about continuing to do this as a tradition alongside Berkshire Weekend going forward.
- [06:41]
Daniel Munga
Absolutely. I mean, it was the first year without Buffett. I know that you've been there when Mungo was also still there. So I felt like it needed a bit of more energy, and hopefully, for a lot of people there, our kind of little conference could bring that. And, you know, maybe it also helped the sentiment that stocks started to recover a bit in the weeks before Berkshire. Microsoft, again has also seen a small rally recently. I think it's about 10, 15% up, if you look at it just from the lows. And I would still say it's on the cheaper side. And I think it's safe to say that the prior selloff, just looking at the numbers, was overblown. I mean, the stock was down 23% after its earnings report at the end of January. And when that's the case, you would usually think that they reported some terrible numbers, but instead, they grew the top line about 17%. Operating income grew 21%, and earnings were actually up 60%. And all of that on a base of $350 billion. In revenue. So that's just incredible. And part of the market's disappointment was that Azure, which is of course Microsoft's cloud business, only grew 39% instead of the expected 40%.
- [07:47]
Sean O'Malley
Gosh, Daniel, what a terrible mess. I mean, how could they drop the ball so badly? 39% growth? Come on.
- [07:53]
Daniel Munga
I know, it's outrageous, but no jokes aside, I mean the market also disliked the massive capex investments, right? So long story short, the earnings reaction is certainly overblown. However, I gotta say that there are some potential long term risks that are certainly worth looking into.
- [08:08]
Sean O'Malley
Well, you touched on the capex investments and so are these your long term concerns around Microsoft being more capital intensive essentially while yielding comparatively lower rates of return on those investments as they have in the past, or is something else on your mind in terms of the risk profile for Microsoft?
- [08:27]
Daniel Munga
That's one of the things that the market is scared about. And you know, Wallace, we talks a lot about it and we will certainly get into that. But I think personally I see bigger risks for especially the legacy Office products and that's still a huge part of profits and also kind of a key part of how Microsoft's business model actually generates profits and works in general. I mean, Microsoft excels, no pun intended, at kind of bundling products and they are just a master copycat and all of that is a bit more difficult in the age of AI and I think that's what we get into. But perhaps I'm also just a bit naive on the cloud investments. I mean, just as with Amazon and Google, I'm kind of convinced that Azure will grow into the demand and even if they overbuild capacity in, let's say, the short term, I just don't see that as a long term drag on the overall business. I think the bigger question is what happens to this $70 billion profit pool still sitting inside their software business? And without spoiling too much, I think it's safe to say that there's a lot to talk about today and I see surprisingly many posts, especially on social media, asking whether there even is somewhat of a reasonable bear case to make for Microsoft. And I do think that's the case. I was actually surprised by how many things maybe how complex the business is and how many challenges it's going to face. When I started my research, I don't think that has been the case, at least to the same extent when we looked at Google back last year.
- [09:49]
Sean O'Malley
So we recently had a call in our mastermind community about moats and particularly switching cost moats and Microsoft naturally came up as one of the most entrenched companies in the enterprise software world. But listening to the thoughts of some of our members who work in and with AI daily and, and who work at some of the most tech forward companies in the world, it did give me some pause in how they think about things. So I do agree that it's certainly a more challenging position that Google was in when we first looked at it. But before we end all that, give us an overview of Microsoft's business first. There's so much to cover that we need really firstly an idea of what we're getting into here.
- [10:28]
Daniel Munga
Yeah, I think you mentioned before that everybody knows Microsoft, but actually getting into the business and then so many different segments, it kind of helps to just give an overview because it's such a huge and complex business. So generally Microsoft has three different overarching business segments. And really the power of Microsoft has always been about the way those segments and also those products in their segments reinforce each other. So the first segment is called Productivity and Business Processes. And this is, you know, the classic Microsoft. At least you know what I think of when I think of Microsoft. So you have the Office tools that are now sold almost entirely as a cloud subscription called Microsoft 365 or 365 and then you have Teams, which is their enterprise collaboration platform Here internally at tip, we mostly use Slack, but it's basically the same thing. Then you have Outlook for Emails which is the same thing to Gmail, Google. Then you have SharePoint and LinkedIn which I constantly forget that it even is a part of Microsoft. And then you have things like Dynamics, which is kind of their enterprise resource planning suite. And this entire segment is generating about $120 billion a year and it's still growing in the mid teens. And I mean the margins look fantastic. It's approaching about 60% operating margins, which makes it really one of the most profitable software businesses the world has ever seen.
- [11:49]
Sean O'Malley
It's incredible to see those growth rates in a business that feels like it's been around for decades, which it has. And the products in many ways have really not changed and are still doing that well. Right? I mean Excel might look a bit different, you know, it's cosmetically definitely improved, but generally it is functionally the same product today as it was 20 years ago in many of the most important ways.
- [12:14]
Daniel Munga
The reason Office365 is so doable is that it's generally woven into the daily workflow of, you know, hundreds of millions of people and companies worldwide. So There's a reason we used Excel repeatedly in our constellation and topics episodes to kind of explain how exactly horizontal market software works. And that mostly is that it dominates so many different industries. Pretty much exactly the opposite of vertical market software. And the same is true for PowerPoint and Word, and they are even the standard now when you work with AI. So I usually work in Google sheets, but when I work with Claude, for example, it kind of defaults to Excel. And that tells you something, I think, about the format's doability.
- [12:56]
Sean O'Malley
Yeah, we'll certainly talk more about that because it's important to today's conversation. But I would like to go just on a short tangent about LinkedIn. I'm just looking at the numbers here and I'm surprised at the size of the business and it does not look like a bad deal in hindsight at all. Right. Microsoft bought it for $25 billion in 2016 and a lot of people thought that they overpaid at the time. And now it has nearly a billion members and something like $18 billion in revenue, which I'm not sure how because I've tried some of the various LinkedIn Premium offerings to connect with advertisers and yeah, long story short, I got really no payoff at all from it. And so clearly people savvier than me are finding it worthwhile to pay for premium LinkedIn. Even though I almost certainly disregard every sponsored message I get on LinkedIn.
- [13:46]
Daniel Munga
Yeah, it seems that also for me, kind of my first instinct is to question everything that sounds good and comes my way through LinkedIn. So I was a bit surprised when I saw those numbers too. But there are generally three ways LinkedIn makes money. And the flagship product is LinkedIn Recruiter. So basically a seat based subscription that costs about $900 per seat per month. So it's certainly targeted at this point corporate tier. So it's nothing that you and I would buy. And they basically give recruiters access to the full billion plus member database with advanced search filters. And there's also a light version of that, I think that's about $170 per month. And beyond that, companies mainly pay for promoted postings and also some labor market analytics products. So they actually run about 6,000 to $20,000 per year, which is kind of insane to me because if you think about that on the high end, that's the cost of a Bloomberg terminal. And then you have Talent Solutions, which is probably the most cyclical business because it directly tracks hiring activity. So when companies freeze hiring, as happened in late 2022 and also late 2023. Revenue just takes a direct hit. And you know, that's why LinkedIn's growth also slowed. If you look at a chart, you would see that to single digits recently, despite the platform still growing in users.
- [15:01]
Sean O'Malley
And the second big pillar, and this is what I was using, is marketing solutions and advertising. And so that's around a six to seven billion dollars business I understand. And you know, you can see the high quality audience that LinkedIn has based on the CPMs that they charge. That's an advertising rate term and they're meaningfully higher than other social media platforms. And that's because it's primarily B2B marketing. You're selling enterprise software or professional services. LinkedIn's targeting by job title, seniority and industry is, it is objectively incredibly robust. And I saw that for myself. My problem was in getting people to respond to messages after I identified who the right contact was. But I digress. So, you know, finding the right person is great, but if there's a culture of ignoring DMs on LinkedIn, there are limits to how much that can be monetized. But anyways, nevertheless, marketers generally do accept this higher cost per Click Rate on LinkedIn. The higher CPMs because conversion rates are either higher or just the leads they're getting are more valuable.
- [16:08]
Daniel Munga
As listeners can see, Shauna is kind of a grudge when it comes to LinkedIn. I mean, probably it also takes some time to kind of, you know, figure out how to exactly work with it and see how you can make or get most value out of it. I think a lot of people are, otherwise, you know, they wouldn't have those numbers. Although they do seem a bit surprising to me as well. The last part that we haven't yet talked about is premium subscriptions. And there's basically the career option if you look for a job, for example, and then there's the business and sales navigator. And this part of the business is growing the fastest, but it also is the smallest of the three buckets. So I think generally LinkedIn, despite our unsuccessful use of it, is a much better business than I expected when I just started my research here. And it will actually be interesting to see what it would be valued at if it were a standalone business because it's not a vital part of Microsoft. And I think as long as Microsoft owns it, I just don't see how it would ever grow to a size or especially a revenue pool where it makes any difference for the overall investment thesis on Microsoft. So to get back to the Office products. They also count in this first segment. And as most probably know, the Office suite went through kind of similar changes to our portfolio holding Adobe about 15 years ago. So originally they were basically sold as this perpetual license. I still remember in school when you had Office 97, when they didn't upgrade it for a long time, or maybe Windows xp where basically those products were bought at a store and then once you had them, you owned them forever. So for Microsoft, that would basically mean that you book all the revenue immediately, but also you had no idea what the next quarter would actually look like. And when you move from selling Office for, let's say a $400 one time payment to only charging $12 per per user per month on what is mostly like an auto renewing subscription, revenue becomes recurring and predictable. And that's what Adobe wanted. That's also what Microsoft wanted and that's why they went through this change. I think it's also important to note that, and we said it for Adobe too, this hasn't been the new holy grail. When it came out like a lot of people were acting like you basically lose out on $400 that you immediately can get by hoping people would stick with your product for only $12 a month. Today though, Microsoft has 450 million commercial seats, which is just incredible if you think about it, at an average of roughly $25 per user per month. So that's generating over about $130 billion per year in essentially pure recurring revenue. So that's just an incredible business. And once again, it's also high margin. So this segment alone makes about $77 billion, not burning profits. And if you adjust for, you know, LinkedIn that we just talked about and some of the other smaller operations in this segment, I think there's an argument to make that probably about $70 billion comes from only the software solutions alone. So we are talking word, we're talking PowerPoint, and we're talking Excel. And if you just think about that, it's an incredible business, especially if you think about the 20, 30 years that it's already operating. But also, I mean, that single profit pool is larger than the total revenue of most S&P 500 companies. And it has 60% margins. That kind of feels ripe for disruption. Right? Especially if you think about AI coming, you can kind of get a glimpse that this might not work for the next, let's say, 20 years.
- [19:17]
Sean O'Malley
Right. And so then the CEO of Microsoft, Satya Nadella, has said in public on multiple occasions that software apps could just Go away, vanish. And that's a pretty remarkable thing for any CEO to say, especially when that would be incredibly bearish for you as a company. Right. It's not something I would have expected him to say publicly.
- [19:41]
Daniel Munga
On one of our last episodes, we actually talked just recently about the fact that no CEO sees their own company threatened by AI, at least not publicly. And then Satya Nadella came out and has pretty much done that. Although to be fair, he's also doing that while expecting Microsoft to become a winner in this new era of AI. So he's technically also just, you know, marketing Microsoft's new products. When he does that, it's kind of similar to what Salesforce's CEO Mark Benioff also did. Right. So basically the question for us as potential investors is how much of that $70 billion survives this AI transition? And also how long would that transition take and what does Microsoft replace it with? Right. If you don't just want to lose the customer, you have to give them something else. And we will come back to this detail. I mean, it's kind of more than a detail. It's basically the whole story about Microsoft. But for the sake of keeping it simple, I would say we first finish the segment overview because I know we're teasing a lot today, but that's just because I fear we will kind of forget things when we're not at least going through the business segment one by one. So the second big segment is Intelligent Cloud, and that's also where Azure is basically the core of. But you also have things like SQL servers, Windows servers, and GitHub. And this segment generates about $125 billion in annualized revenue. So it's about the same size as the first one. However, it is growing at 29% per year. And that's a lot more than the first segment. Right. Azure itself actually has a run rate by now of $75 billion per year, and it's growing at almost 40%. Again, only 39. What a bummer. In contrast, though, to almost every other Microsoft product, Azure is not a subscription, but a consumption based model. That's also what we've seen with a lot of the other clouds. They basically all work the same. So you pay based on how much you actually use the product. And this means that, you know, revenue can pretty much grow explosively in periods where you have rapid adoption. But then when customers become more efficient with using your product, which just naturally happens as they kind of master the platform, the revenue can also de. Accelerate. Right. And that's what you've seen, for example, in this optimization cycle that 2022 and 2023 have been. And then it started re accelerating because you just had this new AI wave that basically created a whole new vector of demand.
- [21:54]
Sean O'Malley
I mean, we've kind of laughed at it, but it is absurd if this premise is true, that the cloud business is growing at 39% and that is the reason, you know, falling short of some sort of market expectations for the stock to sell off. But before we go deeper, there is one more segment we need to talk about. So what is the third segment?
- [22:15]
Daniel Munga
The third segment is more personal computing. And that's where you have Windows, Xbox, Surface devices. And since late 2023, you also have a gaming business because you basically bought Activision Blizzard for $75 billion. By the way, that's the biggest gaming acquisition people have ever seen. And it's not like it didn't make any impact. I mean, gaming for Microsoft is a business also generating about $43 billion in revenue. So it's not nothing. I mean, Xbox Game Pass, for example, has about 40 million monthly subscribers, but this segment is certainly the lowest margin and it's also the slowest growing of the three. So again, kind of like with LinkedIn, it's somewhat of a great and interesting business, but it's also not central to why you would own the stock today. I still want to shortly touch on the gaming business though, also because I know that we got some feedback when I said that I would cover Microsoft that some people are interested in. So I will talk about it. And I would also say it's interesting that if you spend $75 billion on an acquisition, again the biggest in gaming history, and checked it, roughly double what Disney paid for Lucasfilm and Marvel combined, I kind of assume that you have a good plan for the IP that you bought. So, for example, what is that? You have Call of Duty, which has sold tens of millions of copies annually for almost two decades. You have World of Warcraft, which also still has millions of paying subscribers, and then a bit lower quality, but also more people playing it. Candy Crush, which has hundreds of millions of monthly mobile users. And I would say that the main idea has probably been to turn these games, maybe except for Candy Crush, into system sellers for Xbox and their game Pass and basically making it a no brainer subscription for every game out there. It's kind of like what we talked about with Netflix, where they wanted to buy even more ip, so that subscribing to Netflix just feels like a no brainer. If you think about the competition. I think it's safe to say that for Netflix, it worked. For Microsoft, it didn't work at all. It clearly hasn't happened. I didn't ever at any point saw more people buying an Xbox or. Or buy and then game Pass. So now Microsoft has essentially stopped trying to win this traditional console race. It's also something that we talked about with Nintendo, and it's kind of pivoting to what they call an Xbox everywhere strategy. So essentially that would mean that you can access the game pass across devices and cloud infrastructure and you're not dependent on actually owning an Xbox anymore. I think they will not stop producing an Xbox. There's this project which is codenamed Project Helix, and, you know, it's rumored to play both PC and Xbox games. I think to me it sounds like a great idea on paper, but I kind of lack conviction that Microsoft can actually pull this off, just given how little they have done with the acquisition of Activision so far.
- [24:57]
Sean O'Malley
It doesn't seem like too bad of an idea. We just saw the huge success of the Switch 2. So consoles, though, are getting more and more expensive, and focusing on an ecosystem around something with much cheaper and more flexibility seems like a pretty good option to me. But, you know, maybe the way to think about it is the Netflix of gaming of sorts, and you have this huge library of games that you can access no matter where you are and regardless of what type of hardware you're using. That feels like really democratizing gaming in a way.
- [25:33]
Daniel Munga
I guess you can view this as either an upside optionality or also a potential opportunity cost. But no matter how this turns out, again, it will be relatively unimportant to the overall thesis for Microsoft.
- [25:46]
Sean O'Malley
All right, well, let's get back to the topics that are key to the thesis and talk more about the Office products in particular. So I think there are two ways this segment could get disrupted going forward. The first is by facing competitors that have a new chance of disrupting the Office ecosystem by leveraging AI more effectively. And so one of our Mastermind members just recently posted a chart that applies Clayton Christensen's disruptive innovation theory to Google's and Microsoft's productivity suite and basically asked, why couldn't Google disrupt Microsoft Office after winning the lower end of customers? And so Christensen's model for context predicts that a cheaper, initially inferior competitor enters at the lower end of the market and then improves over time and eventually marches up market to displace the incumbent. And so Google launched docs, sheets and slides all the way back in 2006, and they won the low end of the market. You had a lot of individuals, students, and small businesses that really rely on those products, including ourselves. And then still 20 years later, Microsoft Office completely dominates at the enterprise level. Right. Large corporations are not using Google Sheets. So if you assume the average time it takes the new competitor to catch up based on Christensen's model, the crossover where Google's products should have met the demand of more professional users, well, that should have happened in 2018. So the interesting question to me is, why has that not happened?
- [27:23]
Daniel Munga
I still remember that many, many years ago, before I started investing and kind of ever heard of things like a mode or switching costs, I used Google Docs for the first time. That was still back in school. And I immediately asked myself, why does anyone still ever use Word? And funnily enough, I never used Google Docs again up until I started at tip. So that kind of explained it. But anyway, now I kind of know about things like moats and like switching costs. And I would say there are multiple reasons why Google didn't succeed in kind of disrupting Microsoft Office Suite. So the first is that Christensen's model was mainly built around hardware innovation, end products, not embedded in these larger ecosystems that we currently see. Right. So software with dominant file format standards is kind of different. You know, the word, the Excel and the power performance have become international standards pretty much embedded in contracts, legal filings, and just all sorts of documents across millions of organizations. And this kind of reminds me of Adobe's Mode regarding the PDF file format. So you as a person, or even as a company, you just can't switch unilaterally. Right. Your entire professional ecosystem has to switch kind of simultaneously. And now it is relatively easy to convert a Google Sheet into an Excel file. But that's where we get to the second reason for why Google's workspace couldn't disrupt Microsoft. And that is that at the high end, especially for enterprises, the users are still doing fundamentally different jobs than the average users. So the Excel power user building, I don't know, a leveraged buyout model with custom VBA macros, they don't use Google Sheets because Google Sheets just doesn't offer all the same features. And even if the majority of employees don't need those features, as long as any meaningful number does. So let's say the enterprise has 5% of their spreadsheets that are way too complex for Google Sheets, then they still need to just stick with Excel, because first of all, those 5% of sheets might be the most important in the company. And also you would just make sure that everyone in your company can use the product, even the top 5% of users.
- [29:25]
Sean O'Malley
And to be fair, Microsoft has not entirely just stood still. They ran their own counter disruption effort by launching Office365, which offered cloud delivery, automatic updates, and collaborative editing as well.
- [29:41]
Daniel Munga
Microsoft did try to adjust, although I have to say that working collaboratively in a Word document is a complete nightmare. I mean, it works great in Google Docs, so I would somewhat question how successful those adjustments actually were. And then perhaps the last reason are just that you don't only have network effects within your own company, but also with people from other companies that want to receive a file in a certain format. And also that switching software in large enterprises is just always a headache. And there's a huge bias to just stick with what works. Actually talked to Clay a couple of weeks ago for one of our last episodes, and he just talked about prior in his corporate life, how difficult it could be to actually change software like a big corporation. And it's such a huge headache that even if there's some value to gain and you may be a bit more effective, you generally just don't do it.
- [30:31]
Sean O'Malley
So the takeaway for me is that Christensen's model was right for the bottom half of the market, but it wasn't good enough, or maybe there was too much of a change to disrupt the enterprise level. So you told me offline that I may be able to change that dynamic. And so maybe we can reopen the door to the conversation of the innovators dilemma still being relevant and Google finding a way to disrupt Microsoft's basically legendary productivity suite. Is that something that's truly possible?
- [31:04]
Daniel Munga
I think we can. I think the innovator's dilemma is not yet dead. So basically, Google failed to disrupt the Office suite because Google was offering a competing product. And a competing product always runs into kind of the same structural barriers that we just described. What AI is doing, at least I would argue, is categorically different. So AI is not offering a competing product per se. AI is essentially reducing the need for the product. So when someone used Google Docs instead of Word, they were still spending the same amount of human time creating documents, basically just in a different environment. Right. So the job was to create a document, and then Google was a different tool for the same job. But when someone uses an LLM to generate a first draft in, let's say 30 seconds, and then spends 20 minutes editing rather than two hours actually creating that first draft, they fundamentally changed the human labor intensity of that task. And Microsoft's per seat subscription based model is kind of built on the assumption that you need one license for each human doing cognitive work. So if AI handles a meaningful share of that cognitive work, then the per seat assumption kind of stops working. And that is kind of why the $70 billion profit pool is at risk in a way that Google without AI could have never threatened it.
- [32:25]
Sean O'Malley
So compared to Constellation Software, for example, where the AI risk is mostly that there will be competing products made with AI, the AI threat here is not about switching to a different product, it's that you need fewer seats because each human is now doing the work of what several would have previously been capable of.
- [32:46]
Daniel Munga
Exactly. And I mean, this is not a new augment either, right? We basically discussed the same thing for almost all SaaS companies that we looked at here on the show. And I would say what makes this a bit different in my mind is that most other high quality SaaS companies that we discussed prior kind of still had a unique product. I mean, no other company can currently at least do what Adobe does. And the same might be true for Salesforce, although to a much lesser extent. So for them, and especially a company like Salesforce, I think that the main problem is that they will likely become some sort of database layer that is then used by AI agents instead of human users. And I would argue that this reduces pricing power. But it's something that we know yet and only the future will tell. And I think that could happen to Microsoft's Office product as well. So companies don't have to abandon Word, they just keep Word as the final format for the finished product. So they keep all the compliance workflows, they keep the governance infrastructure that Microsoft offers, and they also continue renewing the Microsoft subscription, which is obviously the biggest part of the profit pool. But while doing that, they just kind of resist further price increases on, you know, many of the price increases that Microsoft has basically come in form of new and more expensive bundles. So perhaps that's something that Microsoft cannot do in the future, as easy as it's done that in the last two decades. So basically that would mean that disruption not comes through this wave of cancellations, but rather srp. So basically the average revenue per user stagnating and companies just saying we don't pay more for the same product that we even use less than we did five years ago. So even if the seed count holds, the perceived value of that seed would change. And I remember that just a couple of years ago, it was one of the most Normal things to list Excel as a skill on your cv. So there were hundreds of courses online that taught upcoming investment bankers how to use Excel. And I'm just thinking about this now, but to me it feels somewhat ridiculous to still list Excel as a skill on your CV today. And I mean, you can just go into claw at openclaw whatever you use as your favorite LLM and they will create a model with at least the same quality in a matter of minutes. So this alone kind of shows you in a nutshell how much the skill, advantage and the kind of embeddedness of a tool like Excel have been disrupted.
- [35:05]
Sean O'Malley
The day up and coming investment bankers stop listing Excel as a skill on their resumes, that is the day I will declare Microsoft Office's moat as dead. Obviously joking there. But you know, when you go just app by app, it is pretty remarkable to see the disruption, right? Word is arguably the most exposed to disruption risks. And so the activities that really represent the majority of time spent in Word, whether that's drafting from scratch, rewriting and restructuring, summarizing, reformatting bodies of text, that is precisely where large language models are already very good. And we're honestly good at that a couple years ago. And so that is also probably the most used feature outside of AI power users is those purposes. So, you know, we are guilty of that ourselves, although we certainly lack the skill or knowledge to really manipulate Microsoft Suite as much as we could using different AI tools.
- [36:09]
Daniel Munga
I just realized how little I know about LLMs when we recently had one of our, I would say AI experts lead a call in the community. At least I wasn't alone because it turned into a hundred minute call just because no one wanted it to stop. And as you know, we even have a member who is part of OpenAI's team that is basically tasked with training their models and all of the financial stuff. And even for him, much of it was still new. So I certainly came out of the call a lot more bullish on AI and also a lot less bullish on software. Not because it will go away, but simply because of this database agent dynamic that we discussed earlier and also the fact that everything we've seen up until now is still only the beginning. So in theory, the tools that we currently use are the worst versions of LLMs and AI tools and they will only get better. And that's kind of scary if you think about them, especially how much better they have gotten in the last just two years. I mean, you said it, you could basically draft a Word document two years ago, but the amount of detailed work that, for example, Claude can now do. That's something that ChatGPT a year ago just couldn't do anyway. You're all right to say though, that Word is probably the most exposed and integrating Copilot, which is kind of Microsoft's answer to, you know, the other AI models, just didn't really help either. Not only is it very limited in what it can actually do, but at least with a satisfactory result. But most people also just don't start in Word anymore, so they go directly to Claude and then just make some final adjustments to the Word file that Claude has generated.
- [37:41]
Sean O'Malley
So that's what baffles me, because why does Copilot struggle so much still with generating useful output inside of Word, right? I mean, it seems like creating tables or similar things like that are really what it struggles with most. And a lot of that stuff could really be a nightmare if you're having to do it yourself, right? I mean, formatting things in Word has always been a problem throughout my entire life. It can drive you utterly crazy. And it seems like even with large language models, Microsoft has not cracked the code on how to make Word useful to people, at least from reformatting things
- [38:18]
Daniel Munga
I was talking about. That kind of gives me flashbacks to my bachelor thesis that was a nightmare. I mean, not the thesis itself, but the formatting in Word. I mean, you want to change the positioning of just one graph and your entire 100 page document is all over the place. But yeah, letting that behind me to answer your question, what was designed as a tool for human creation first? And that's something that I also got as feedback, especially from programmers lately. So the entire paradigm basically assumes that a human is doing the writing and the work in Word, and that makes it just not the best interface or just environment in general for an AI to do its work. So something like Latex, for example, is much better at that. And that's, you know, the different angle of competitive pressure where you had Google prior and now basically reducing this skill. Part of using Excel helps Google Sheets. And at the other end of the spectrum, you might have tools that are just way better fitting for AI like Latex, and they, you know, could get a boost that they have never seen before. So perhaps that's the long term risk that, you know, many people are thinking about when they think about Microsoft. So the less important Word becomes because we use it much less, the more likely it is that a tool will take over. That just works much better with AI than Word because it's AI first instead of Assuming a human user as, you know, the main starting point, just to
- [39:42]
Sean O'Malley
move on to the next app in Microsoft's productivity suite, PowerPoint seems like it's been similarly vulnerable to disruption. And, like, the pace and quality at which AI can generate a complete slide deck has improved enormously just in, like, the last, like, four months, it feels like. I'll be the first to admit that Claude has helped me build a number of PowerPoints at this point. And, I mean, I provide it with the information, I'll give it kind of a narrative structure, but then it does all the formatting and presentation work, you know, much better than I ever could. And honestly, like, maybe 100 times faster than it would take me to do it.
- [40:22]
Daniel Munga
It is incredibly helpful. Although I got to say, just in the last couple of weeks, I got highly allergic to presentations that look like AI immediately, especially Claude, because, you know, that's what everyone is using nowadays. So I think it's completely okay to feed it the data and then kind of let it create an outline. But when I see that someone just uses the presentation that came straight out of Claude or ChatGPT, I kind of immediately discount the value of the presentation. I know that's not the smartest thing to do. It can still be your own data, your own research. I don't know, it just kind of gives me the ick if I see that. But, Yeah, I mean, PowerPoint's core value proposition has always been to lower the barrier to creating visually coherent presentations. And that basically is what AI has now essentially collapsed. So that barrier is now. Before was at like 20%. It's now at zero. It's just there is no barrier anymore. You just, you know, give a hint or a prompt to Claude and he will do whatever you want. And again, it feels so much easier to just ask Claude compared to copilot in PowerPoint, that it's just ridiculous. You would feel that Copilot should know word, should know PowerPoint and all those tools better, but if you compare to these generalist LLMs, they just tend to do a much better job. So a year or two ago, you could have still argued that AI is quite good at creating a first draft, but it has problems improving the presentation when you have things to adjust afterward, for example, with how the presentation looks. And that's a problem that's bigger than you would first imagine, because many companies have these individualized templates. So if AI can't use them properly, you really just can't use the presentation at all. But that's no longer the case. Either. I mean, if I want Claude to come up with a template for me to use, and, you know, I just upload, then I just upload some presentations that I have done before and tell Claude, pretty much do exactly what these presentations have done and use this data, and the result is pretty good.
- [42:10]
Sean O'Malley
None of that sounds very positive for Microsoft, right? I mean, is there anything that should make us bullish on the future of these Office products? This is a $70 billion profit pool, after all. So not feeling bullish about this, really, the whole thesis feels impaired.
- [42:29]
Daniel Munga
Yeah, I should emphasize that what we have discussed by now is basically the bear case, right? I mean, the unsettling part about that is that, at least to me, it seems kind of realistic, and to some extent it is currently playing out. Nevertheless, though, Microsoft Office is still the dominant player, and Even all the LLMs use it to generate their results. So I think we don't have to say that Microsoft has no chance of getting back here. And the bear thesis here could also quickly turn into a bull thesis if Microsoft were able to turn Copilot into an actual value add, which might only be a matter of time and, I don't know, organizing within the companies that use it. If that's the case, the Runway itself is still huge. Only 3.3% of Microsoft existing customers have paid subscriptions for Copilot. And if there's one thing that Microsoft excels at, it is bundling things together and just increasing the conversion of their product. And also generally, and that's something I learned recently, LLMs are about equally good, so some are better at specific things than others, but it mostly balances out. So the reason for Claude's sudden success, for example, has not only been its new model and how much better it is than, for example, ChatGPT, but mainly its ability to use user context in cowork or through its agents. And that seems to be Copilot's struggle, although this should have been its advantage. So it's difficult to access all the necessary data because most companies, without even knowing it, have highly unsorted files. So basically, files that meant to be confidential are technically accessible to people who shouldn't see them because nobody cleaned up the settings when, I don't know, a project ended three years ago. So this existed for years pretty much with no consequence, because most employees don't hunt through SharePoint folders they're not supposed to, because they want to find access to files that they shouldn't have access to. When in turn, though, you turn on Copilot, and it starts reasoning across everything that your account has technical access to that file mess quickly turns into a problem. And I've read about several enterprises that basically ran early pilots on Copilot and kind of figured out that there was information surfacing that shouldn't have been surfacing and that employees have access to files that they shouldn't have access to. And that's obviously a huge problem if the main argument for using Copilot is that it only has access to the files and to your corporate identity that you want to give it to, Right? So maybe one last thing I should mention about Copilot is that you have access to all kinds of models by now through Copilot. So you can also use Claude, and you can also use all the other favorite LLMs that you have. And that's obviously a good way to make sure that people still access them through Microsoft and use Microsoft tools when they do. So there's certainly a future where I would say pretty much nothing changes and everyone stays subscribed to Microsoft Office only. The only difference is fewer human hours in Word, Excel, or PowerPoint. And also if you bundle all the products together, you can also justify price increases, even if the Office tools are used less than in the years before that.
- [45:30]
Sean O'Malley
So to summarize, the major problem for Microsoft right now is that this is probably the first time in many, many years that you have even been able to come up with what is a plausible bear case against the Office segment. And that just has not been the case for a long time. And if you're a company that traded at 40 times earnings, then the market is expecting really no signs of any potential risks. It's just not baked into the price of that kind of valuation. Otherwise, if uncertainty like this pops up, your stock is going to get dramatically rerated. And, well, that is a pretty quick summary of exactly what has happened to Microsoft stock in the last six months.
- [46:13]
Daniel Munga
I would say that's accurate. I think we've seen the same thing when we had our portfolio review episode and we talked about fico, for example, if companies traded these premium multiples, you just can't have anything happen that just looks like a bear case.
- [46:24]
Sean O'Malley
To your point, though, I have just seen recently that you can now directly integrate Quad, inside of Word, inside of Excel, and also inside of PowerPoint. And so at first, I think that does seem a bit odd because it is basically replacing exactly what Copilot is supposed to be there for. It's almost like they're acknowledging that their own model isn't good enough, maybe, or Maybe it's just part of a more model agnostic approach that maybe put it more nicely.
- [46:53]
Daniel Munga
Yeah, I've seen that too. I think it's still in beta, but I think this will ship pretty soon. And I think it's not easy to say how this will turn out. I mean, on one hand this is obviously competing directly with Copilot, but on the other hand, it at least ensures that people are still using, you know, the Microsoft tools, like Word, like Excel, like PowerPoint. So I think it kind of makes sense. And also to some extent you still benefit because Claude, for example, goes at least to some extent through Azure. So Microsoft is monetizing that through the cloud business.
- [47:25]
Sean O'Malley
That's a good point. And perhaps that's a good time to leave Office behind us and talk more about Azure and Microsoft's cloud capabilities, generally where I think we have more leeway to be bullish responsibly. Right. So to understand this segment properly, we might first want to discuss the three layers of cloud computing and where each major provider competes. Cloud is talked about a lot. It's one of those buzzwords you always hear, but understanding what that actually means is really not very straightforward. So at the bottom layer is infrastructure as a service, or you'll see this abbreviated as the acronym iaas. And so this is raw compute, storage and networking, rented by the hour or the second. And you essentially get a virtual machine or container, and then you're responsible for everything that runs on it, and then AWS. Amazon Web Services pioneered this model in 2006 and continues to lead with roughly 30% of the global cloud infrastructure market share. Azure is at about 20 to 22%, and then Google Cloud is at about 13%. And so the three of them control more than 60% of a global market that crossed $100 billion in a single quarter in Q4 of last year, growing at a rate of roughly nearly 30% year over year.
- [48:52]
Daniel Munga
It's pretty astonishing to me just how stable the market share has been between these three players. While all of them had fantastic growth rates over the last few years, they didn't really gain share from one another. So it's a bit odd because technically this is a business or segment where there really isn't a huge moat naturally to that business. So the compute you offer is more or less commoditized. At the same time, though, it is very capital intensive to build the data centers. As we all know by now, when just looking at their capex investments, and then when the market is dominated by the likes of Amazon, Google And Microsoft, you can kind of imagine how much capital you would need to play in their league. So although it's technically difficult to differentiate your product, they're just high enough barriers to entry for this to be a profitable oligopoly. And there are also huge switching costs over time, which is why customers usually don't switch from, let's say, AWS to Azure or Google Cloud and also the other way around. So it basically comes from this factor that the more moaty part of the cloud business is the second layer, which is called platform as a service or PaaS. Unfortunately, all those acronyms are not sounding as good as SaaS when you just, you know, spell them out. But this is basically where developers get pre built services. So we're talking databases, machine learning platforms, especially for Google's cloud, and some developer tools. And this is where Azure has a structural advantage. Since Microsoft owns GitHub, which is the dominant global code repository, everybody who codes will likely know GitHub and also visual Studio, which is the most widely used development environment in the world. So if you want to build Your application on GitHub using Virtual Studio and want to deploy it, it's pretty much impossible not to use Azure as your cloud service.
- [50:39]
Sean O'Malley
So Azure's competitive advantage is about having captured the developer relationship, which is where a lot of these cloud decisions are being made. And so that helps with onboarding new clients, especially at the enterprise level. Is that the right way to be thinking about it?
- [50:55]
Daniel Munga
Exactly. And it kind of goes back to this competitive advantage of just bundling everything, right? If your ecosystem is so huge that everything is interconnected. And we haven't yet mentioned this term of a flywheel today, but you can only talk about it where everything is, you know, going hand in hand with each other. And basically one plus one equals three, right? And this is how Microsoft operates. And there's also the third layer of the cloud business above Platform as a Services, which is the actual software applications that business users interact with. And that's what we all know, even as consumers. So we are talking Microsoft 365, we're talking Teams, we're talking dynamics, and Microsoft really is the only major hyperscaler simultaneously competitive at all three layers with an enormous installed base at the top. So aws, for example, has virtually no enterprise software presence. And Google Workspace competes at the application layer, but as we've discussed in pretty much 30 minutes doesn't have Microsoft's death or enterprise penetration. So that has been a huge tailwind for Microsoft Cloud and it's in part why they could have this, know, second position in this incredibly profitable market.
- [52:02]
Sean O'Malley
I don't want to be the one to keep bringing up the bear case, but in my defense, Microsoft CEO Satya Nadella is the one who's really bringing it up and beating me to it. And so he talked about what happens to the platform layer, specifically when AI agents can just bypass it and what the implications of that are. So what are your thoughts on that and what that means for the future of Microsoft's business?
- [52:29]
Daniel Munga
Satya Nadella is not holding back on the massive changes that might come for Microsoft. And I mean, that's also why he doubled down so massively on Copilot and he basically didn't want to get disrupted. You know, he wants to be the first mover. He does not want to be the victim of the innovator's dilemma. Generally this is what you want to see from a CEO, but it's the fact that the execution part has really been lacking. So the comparison might be harsh, but it even somewhat reminds me of what Mark Zuckerberg did with the Metaverse. So he basically rebranded the entire company and invested hundreds of billions and it all ended up failing miserably. And Microsoft now has almost 80. It's 80 different products with the name Copilot in it. So their new laptops even have their own Copilot keys. And yet it is still such a big disappointment up until now. So coming to your question, and this is kind of an introduction to that, why might the platform as a service be getting disrupted? So the reason the platform layer has been so valuable and so sticky is that it basically solves a complexity problem for software developers. So if you want to build an application that needs user logins, for example, you don't have to build your own password database, your own multi factor authentication system, or your own single sign on infrastructure from scratch. And it all sounds pretty complex when I say it out loud, but it's just that Microsoft really takes a lot of the things that you would otherwise have to do on the back end and simplifies it. So instead of building all these password databases, you just call Microsoft Entra id, which is this identity management service at the platform layer. And that service takes care of everything that you need. And the same exists for database management, message queuing, and also analytics. So the platform layer is a collection of these pre built tools that developers can use. And the reason that creates stickiness is that once you build your application on top of Entra ID or Azure SQL or even Azure Machine learning, those services are basically integrated into your code. So the problem comes from what Nadella has described as being CRUD plus business logic. And CRUD stands for create, read, update, delete plus all set of rules. It sounds pretty complex, but this is what most software basically is. And an AI agent can now generate its own logic, and that pretty much changes how everything works. So it does not need all these abstraction layers that we just talked about. It can go down directly to the underlying database, get whatever it needs, apply its own logic, and then return the answer. So, say someone wants to know the total accounts payable owed to vendors in a specific region. Before AI, you as a user would open software which calls platform services, which then access the database, which then runs calculations which then returns a result through the software interface. So there are just a lot of layers involved, and you, as a normal employee, wouldn't know that, but that's the case on the back end. An AI agent, though, just goes directly to the database, finds the data, does all the reasoning, and then gives you the answer. So it makes it just significantly easier. And you don't need all these platform layers because you as an employee, you just don't go through them anymore.
- [55:50]
Sean O'Malley
And so that's why Microsoft is trying to turn Azure into a platform for AI agents themselves through Copilot Studio and this agent framework. And essentially, it's a race to replace the old platform layer with a new one before the old one disappears. And you have this melting ice cube dynamic.
- [56:10]
Daniel Munga
That's the bet you're taking. I mean, the question is whether they can execute that transition, what it basically is faster than the erosion happens, and that is not guaranteed. Right? Which basically means there's some sort of uncertainty. And as we all know, markets don't like uncertainty.
- [56:25]
Sean O'Malley
And there is one more dimension to this that I think is worth talking about. Even if Microsoft successfully deploys AI agents at scale, the question then is who actually acquires the economics of those agents. That remains up for debate.
- [56:41]
Daniel Munga
That's a big question, and I think it really depends on what layers of the entire process you still control. I try to keep it as simple as possible, but I will still want to explain the layers and then also please give us feedback in the comments. If you're an expert on this and you kind of have a theory on how it all works out. So the first layer is the software where the agent's output lands. So that would be Word, that would be Excel, that would be PowerPoint. The second layer is the platform managing what the agent does and what data it accesses. And how it's governed across the organization. What does that mean? Basically, what file can they access and what file can they not access? And then the third is the actual AI model generating the output. Okay, so that's Claude, that's ChatGPT, those kind of things. Then fourth is the compute infrastructure. So that's the GPUs physically running the model in a data center somewhere. And Microsoft's aspiration is to own all four of those layers. And then the question is how much of that stack they can actually control. And that mostly depends on whose agent is being deployed.
- [57:48]
Sean O'Malley
I think we need to dumb things down for me, Daniel, because I like tangible examples. So maybe just to go through some scenarios, what happens if an enterprise uses Microsoft's software? So Excel Word teams, but then deploys a third party agent, so they're using Claude or ChatGPT.
- [58:10]
Daniel Munga
So in that scenario, Microsoft obviously keeps the Office subscription because the output still lands in either word, Excel or PowerPoint. But the platform that manages the agent's behavior goes to the model provider or to no one, if the enterprise builds it itself. So, for example, Salesforce wants to build its own agents. In that case, the value would go to Salesforce. The inference margin, which is just the profit margin left after accounting for the operating costs of running AI models, is running at about 60% right now. And obviously all of that would go to anthropic, OpenAI or Google. So Microsoft sees none of that. And then if the enterprise is running a GPT based agent, then OpenAI's models run on Azure, So Microsoft captures the compute revenues on that. But Anthropic's primary cloud provider, for example, is aws, not Azure. So if an enterprise deploys a cloud agent, most of the compute revenues would go to aws. And of course the same is true with Google's Gemini models, which run obviously on Google Cloud. So in scenario one, Microsoft's compute capture depends entirely on which third party model the enterprise actually chooses. So they get it for OpenAI, but they only get it for them. Not if you use Claude, Mistral or any other model.
- [59:26]
Sean O'Malley
Okay, so going to scenario two, let's say it's Microsoft software, plus Microsoft's own agent being, let's say, Copilot. What does that look like?
- [59:39]
Daniel Munga
That's the ideal outcome for Microsoft economically. So they keep the Office subscription. Again, they own the agent layer and the compute runs on Azure. So the catch is that Copilot today still runs primarily on OpenAI's models, meaning Microsoft effectively still has to pay OpenAI a cut on Every single copilot response generated. So even in scenario two, they're not capturing the full value chain yet. That's why Microsoft is investing so heavily in building its own AI models and also its own chips. And the goal is basically to gradually shift Copilot off OpenAI's models and onto their own, so they can stop writing that check and really keep the full margin to themselves.
- [60:20]
Sean O'Malley
And then there's a third scenario in which Microsoft's orchestration layer wraps a third party model that then runs on Azure. Boy, that was a tongue twister. Tell me about that situation.
- [60:33]
Daniel Munga
Well, this is what Azure AI Foundry is positioning for, and it might be Microsoft's most durable long term position if they can pull it off. So in this scenario, enterprises use Claude Llama or, I don't know, even Mistral as the underlying model they access it through through Microsoft's managed platform. So you can imagine it as somewhat of an app store taking cut on everything that runs through the platform, even though the intelligence itself belongs to anthropic matter or whoever has the LLM. And the reason this is the most durable position is that it doesn't require Microsoft's own model to actually win that
- [61:12]
Sean O'Malley
LLM race sounds great in theory, but what's the risk that the model providers just bypass Microsoft and go direct to enterprise customers? Right? If anthropic is good enough, why does a large enterprise need Microsoft in the middle at all?
- [61:29]
Daniel Munga
I mean, that is a possibility, but since Microsoft is already integrated in all of these large corporations on earth and has so much more experience in both the governance and also the regulatory world, I do see why handling it through Microsoft is just a sort of safety layer for enterprises. But even in the best version of Microsoft's platform strategy, the economics of the AI era might look more like Spotify than like the Office era. So Spotify is arguably the best music distribution platform ever built. So an easy to use product. It's only for music. Enormous scale and a dominant market position. We just covered it here on the show a couple of weeks ago, and still the labels still capture roughly 70% of the revenue, leaving Spotify with relatively thin margins compared to most other platform companies. And Microsoft's software era was pretty much the opposite. They were the creator, they owned the content, the margins were extraordinary. And the AI era could shift Microsoft toward the distribution side of the ledger. And that doesn't mean it's a bad business. So Spotify at scale is still a large, important, profitable business, but it is a different margin profile. And I think it justifies A different multiple. And I think that is generally part of why the market is repricing Microsoft right now. And actually we just spent a couple of minutes also figuring out in our heads how exactly it works that you have all these circular agreements where basically you have partnerships with OpenAI or an Amazon's case with Claude. And then all of this compute is to some extent business for you and it's part of the growth numbers of the cloud business. And at the same time, a lot of it is actually paid by vouchers, for example, in this case. So it's not actually money that you receive. Most of the money, for example, for Copilot still comes from the subscription service. So then you can open up the entire argument of who is actually benefiting the most. And I think we'll still talk about it. But if you think about that and then the relationship between Microsoft and OpenAI, it seems more and more that OpenAI is the main beneficiary here, not really paying for the compute, at least not with real money, only to some extent starting in the last couple of years. That all makes it so incredibly difficult to understand who exactly will make money where the margin will be in five years. And it just increasingly feels like this just goes in your too hard pile.
- [63:54]
Sean O'Malley
You took the words right out of my mouth. No, we still got to push through and understand the rest of the business and think about the valuation before we make any decisions about the too hard pile. And I guess the question for investors isn't really does Microsoft make money from AI agents? Because they almost certainly do to an extent in all three scenarios. It's more about how much of the value chain they'll own and what that will mean for the margin structure of the business over the next 10 years. And so the famous example of this that people like to throw around is the airlines. Think about them as creating this massive utility worldwide, right? 100 years ago, I could not just get on a plane in D.C. and meet Daniel in Frankfurt, right? It was just, it did not exist. And in the meantime, these companies have created a way for people to be able to travel anywhere at honestly pretty reasonable prices. When you think about what is actually happening, to take you from one point to another point on the other side of the globe. And yet airlines are historically very, very unprofitable businesses that have, you know, Buffett has famously said that in aggregate, airline stocks have destroyed more shareholder value than they've created. So we were talking about capturing the value. You know, it's one thing to make a great LLM and to be involved in this AI race. But then can you actually capture that value? And with airlines, they have not captured that value. Almost all of that surplus value has gone to consumers. We all benefit from greatly from the existence of airlines. And airlines have really not been able to profit from that. So that's a little tangent, but I do think it's a helpful lens to think about what it means when we say capturing value.
- [65:40]
Daniel Munga
I think it's important to understand that because we all are prone to this recency bias of thinking that the big tech companies mostly are the companies that end up with most of the value for whatever product comes out. But I do feel that to some extent, and it's only gut feeling because understanding this all entirely is pretty difficult. But when I researched Microsoft, it felt more and more like perhaps this paradigm comes to an end, at least for the type of business model that Microsoft has. And this is not a prediction, it's just that it's incredibly difficult to model or kind of understand. We just don't know yet which scenario is the most likely to play out. And if enterprises broadly adopt Copilot, Microsoft owns the stack and compounds at perhaps software era economics on a much bigger scale or dominating a much bigger market. But if enterprises use a third party model, especially if Claude stays on AWS and that becomes, you know, the biggest player in the field, that would be a huge hit to Microsoft. And you know, perhaps you're kind of laying there with this format landlord status that's been systematically excluded from the high margin layer on the AI value chain. And again, the answer is almost certainly somewhere in between those two extremes. But somewhere in between can still mean a lot of different things for a stock that has historically been trading between 30 to 40 times earnings.
- [67:00]
Sean O'Malley
All right, well let's, that's enough on that. Let's talk more about this OpenAI partnership. From the outside, it looks like this could have and perhaps should have huge implications for Microsoft. Most investors thought that it would with Microsoft being able to use chat GPT models for Copilot and how that would have been a major edge. And just 18 months later, OpenAI has gone from being really the anointed champion of AI that seemingly deserves to be a trillion dollar company to now seeming like in many ways it's behind the competition. And we may look back and determine that OpenAI made the fatal choice of getting bogged down with consumer products while the real money was to be made in B2B AI products, which is exactly what Anthropic has prioritized and Yeah, I don't know. If you ask me honestly, that may end up being one of the biggest oversights in 21st century business history. I mean, there will be case studies on it in colleges, you know, 10, 15, 20 years from now, if things keep moving in this direction. So why has Microsoft not benefited more from its relationship with OpenAI and leveraged that tech to make superior B2B products itself? Because now it looks like they both have massively dropped the ball.
- [68:19]
Daniel Munga
I mean, Microsoft made its first investment in OpenAI in 2019. Back then was $1 billion at a time when most of the world hadn't even heard of a company or even just AI. And they followed with additional investments in 2021 and then in early 2023, committing $13 billion more in a deal, giving them roughly 49% of economic interest and an exclusive cloud partnership that we just mentioned, under which OpenAI's workloads run on Azure. But again, a lot of that money are actually these redeemable vouchers. And it actually didn't go from Microsoft in terms of actual cash to OpenAI. And as you said, OpenAI is no longer seen as the best model out there, and it might have missed the best opportunity to play its AI elite. And of course, that makes people ask whether OpenAI will even be able to to come up with all the money that it promised companies that they make business with. Right? I mean, for Microsoft, if you just pay them with vouchers, that's totally fine, but there's so many other companies that they have basically promised hundreds of billions of dollars. You kind of ask yourself, how are they even supposed to make that money? About 45% of Microsoft's $625 billion backlog is tied to these OpenAI relationships. And those vouchers are not enough to cover that. Again, they already start also paying real cash to Microsoft. And OpenAI is far from being profitable. It's burning through cash so fast that it really needs these continuous large funding rounds. So I don't know its ability to fulfill a quarter trillion dollar commitment to Azure alone. I don't know. It kind of depends on just continuing to grow revenue fast enough to then generate the cash to pay those Azure bills.
- [69:59]
Sean O'Malley
A quarter trillion, Daniel, come on. So much money. And then just recently, Cloud actually announced a revenue run rate of over $30 billion that was very much in the news, topping OpenAI's run rate. So we already see competition overtaking OpenAI. I mean, that has already happened, and that does not help with their additional funding needs. And Another negative for Microsoft came when OpenAI announced something called the Frontier deal with Amazon. So maybe you can tell us more about that.
- [70:31]
Daniel Munga
That's the other part of the OpenAI relationship that is just a bit odd. So OpenAI launched a new enterprise AI agent platform called Frontier and signed a $50 billion exclusive cloud deal to run it on AWS instead of Azure, arguing that this new product pretty much falls outside of the scope of the existing exclusivity agreement with Microsoft. So despite the ownership sake of Microsoft, it kind of seems relatively easy for OpenAI, at least if this holds up, to just create new partnerships that basically bypass Microsoft. And if that's the case, you kind of have to ask yourself, with every new OpenAI product, will this be channeled through some competing cloud provider rather than exclusively to Microsoft and its cloud? And then there's also the problem with OpenAI's conversion from this nonprofit organization, which they currently still are, to a for profit company. And there you have all this uncertainty about whether Microsoft's 49% stake or economic interest actually fully converts into a comparable stake in this new for profit entity, should they get there.
- [71:37]
Sean O'Malley
The relationship has started to resemble those early partnerships in the smartphone era where you'd have the platform providers, Apple and Google. They initially needed carriers like AT&T or Verizon for distribution and funding, and then once they had enough scale, you saw that power dynamic just completely reverse. And so OpenAI started as a dependent and, well, look, now it's valued at almost an $800 billion valuation and is increasingly able to act in its own interest, you know, with its own autonomy.
- [72:08]
Daniel Munga
It feels like the OpenAI partnership kind of resembles pretty well how the power dynamic generally has shifted. So in the last 20 or so years, big tech companies just bought whatever company they wanted, and either they integrated them into the ecosystem or they just killed it off to basically just avoid competition. And no matter what they did, they certainly decided how things turned out with OpenAI. I think it feels like there has been for the first time in a long, long time, a company that grew so fast and to an extent that no one could have seen coming, that they grew too big to be controlled even by companies like Microsoft or Amazon. And instead, by now, it kind of looks like Microsoft lost control over them. And when they realized that, they were starting investing even more heavily into the AI model program, you know, run by themselves, which is called Mai, one very simple name, once again developed toward GPT4 class capabilities, of course, at lower inference costs, running on their own Maya 200 chips and the model agnostic foundry model was also launched because of this. So Microsoft is doing a lot. But again this also doesn't simplify the business generally.
- [73:18]
Sean O'Malley
All right, so we have one more thing I want to talk about before we get to the valuation and then we can kind of wrap up today's discussion and that is to talk about capex, which is the conversation being had at many of the Mag 7 right now is hundreds of billions of dollars are being invested into AI and the impact it has on financial. So what does that look like for Microsoft?
- [73:39]
Daniel Munga
Yeah, as you said as every other hyperscaler, Microsoft obviously increased its CapEx spend as well. And just a six months, the first six months of the 2026 fiscal year CapEx is more than $70 billion and the guidance is between 120 to almost $150 billion. And for context, in fiscal 2023 CapEx was in total $28 billion. So Microsoft now spends more on CapEx in a single quarter than in an entire year just two and a half years ago. I think looking back or kind of zooming out, you kind of realize why the market is so scared because of these investments at the capex spend because even for those companies it's so much money. And roughly two thirds of the quarterly CapEx is going towards short lived assets. So primarily GPUs and CPUs and they have, at least that's what it's currently saying, a useful life of about three to five years. And the depreciation charge runs through the income statement. So we already know for a fact that there will be massive depreciation charges coming in the next couple of years, certainly lowering margins.
- [74:42]
Sean O'Malley
So the ROI question then would be at what revenue generation level does all of this spending pay for itself and then on what timeline? Right, like when will that happen?
- [74:54]
Daniel Munga
I fear bring up too many numbers again. But if Microsoft is spending $140 billion a year on infrastructure and those assets need to at least earn their cost of capital, you would, let's say want a minimum of 12 to 15% return. That would imply that you have about 17 to 20 billion dollars of incremental annual revenue generation from the infrastructure. Just to break even, Azure is already generating about 75 plus billion in trailing revenue growing at again close to 40%. And at that growth rate, Azure adds roughly $28 billion in new annual earned you which does clear the cost of capital bar if you believe the capacity being built now will actually be utilized at the current growth rates for the foreseeable future. I think the concern is about the margin of safety here because if Azure growth decelerates to let's say 25% while capex still stays at these levels, then the returns don't look that good anymore and you know, 25%. We just talked about how potentially the current growth numbers are inflated by these circular investments in OpenAI. So it does open up a lot of questions to investors. And since growth even came in slightly below expectations, again, not 40%, only 39%, that's one of the market's fears right now. And although Microsoft CFO has said in the latest earnings call that demand for Azure is certainly there and growth could have been a couple of percentage points higher if Microsoft wouldn't have decided to allocate compute capacity to other parts of their own businesses first.
- [76:27]
Sean O'Malley
Well, to quote her, she said the first thing we're doing is solving for the increased usage in sales and the accelerating pace of M365 copilot as well as GitHub co pilot, our first party apps. Then we make sure we're investing in the long term nature of R and D and product innovation. And much of the acceleration that I think you've seen from us and products over the past is coming because we're allocating GPUs and capacity to many of the talented AI people we've been hiring over the past years. And just continuing with her quote here, there's one more paragraph she says, then you end up with the remainder going towards serving the Azure capacity that continues to grow in terms of demand. And a way to think about that is if I had taken the GPUs that just came online in Q1 and Q2 in terms of GPUs and allocated them all to Azure, the KPI would have been over 40. And I think the most important thing to realize is that this is about investing in all of the layers of the stack that benefit customers.
- [77:29]
Daniel Munga
By this quote alone you might realize that if you will listen to an entire earnings call, how often they would say the word copilot and maybe also how complex the business is and how often they talk about the GPUs, the CPUs, how that changes the economics. And it's all pretty difficult to understand. I think if people tell you that they fully understand what's going on at these companies right now, they're kind of lying. I think it's just incredibly difficult to follow everything that's happening and beyond what the CFO just said, all CEOs of the big tech companies saying the same thing. They would rather overshoot and invest too much than underinvest and lose their competitive position. And if Microsoft under invests and enterprise AI demand is even greater than projected right now, they end up behind on capacity at exactly the wrong moment in time. So losing customers, at least potentially to AWS and also to Google Cloud. We just made the bet earlier, so to some extent I feel this peer pressure. We just have to have these investments just to not potentially lose market share to direct rivals. And I think I do agree with that strategy. If we are at such a big changing point, you would risk losing basically your entire business or at least your position by underinvesting, while overinvestments themselves would kind of only mean a couple percentages less in returns. I mean, we've seen that again with Markus Zuckerberg's metaverse. That was $100 billion flop. I mean, literally no returns at all. And still it didn't really hurt Meta in the long run. So I think the risk of losing your position is much, much larger than the potential of under investing right now.
- [79:00]
Sean O'Malley
And the Metaverse was a complete moonshot. Whereas we already have seen what AI can do and how it can impact business models and profitability. And after spending a lot of this episode on the challenges that Microsoft is facing, how about you give us just a refresher on the bull case? Because I think we're already forgetting why we were initially bullish on the business.
- [79:22]
Daniel Munga
Just to be fun. I mean, we already talked about the three different scenarios that could come for Microsoft. And let's be honest, it's hard to imagine that Microsoft will not play a vital role in software or AI in the future. So the company is still positioned to potentially succeed in all parts of it, the entire value chain. So offering the software tools, running the cloud and the compute, and having a competing model, or at least offer all major ones through their copilot product. A second bull argument pretty much writes itself if you just take a look at the numbers. I mean, Microsoft is still generating approximately $350 billion in annualized and to a large extent recurring revenue, growing at 17% per year. And the operating margin over the Entire business is 45%, which is just insane at this scale. Even free cash flow conversion is still looking good, although it has gone down from about 80% historically to about 50% today, just mainly due to the capex investments. And the company is also returning cash to shareholders. It's about 40 billion in fiscal 2025, mostly through dividends and buybacks. So that's more than any other company in the S&P 500 in absolute dollar terms still, unfortunately, just due to the size of the company, you have a low dividend yield and also a low buyback yield. So they have about $90 billion in cash as well. Obviously a financially stable company. That's not surprising to anyone who listens to this podcast. So yeah, if you just summarize, this is a company that can fund an $80 billion capital spending program, return $42 billion to shareholders, then still show a huge cash pile in the bank.
- [80:53]
Sean O'Malley
And if we want to keep being bullish, there's that backlog number that we should revisit. And so just even setting aside the OpenAI portion, $344 billion is committed in non OpenAI revenue growing 28%. So that does not look like a dying company.
- [81:12]
Daniel Munga
And When a Fortune 500 company signs, let's say, a three year Azure commitment, they're essentially making a statement that, hey, we are all in on Microsoft's AI infrastructure, right? So it's not very likely, at least to me, that they plan on leaving the Microsoft ecosystem anytime soon. Another bull argument is also that they have this custom silicon story pretty much similar to what AWS or Amazon is also doing. So the so called Maya 200, we already talked about them, are deployed at scale in Microsoft's own data centers and early benchmarks, at least the one that Microsoft itself is putting out, suggest that it delivers competitive inference performance at meaningfully lower cost per token than equivalent Nvidia GPU configurations. Let's say Microsoft can shift even 20 to 30% of its AI inference workloads from Nvidia GPUs, which we all know are incredibly expensive to their own chips over the next, let's say two to three years. I think that alone would mean margin improvements that would be very significant for the overall company. Again, Amazon is doing the same, and it seems like it's working out pretty well. Maybe. Finally, before we actually go to the valuation, you also have GitHub, which shouldn't be underestimated. It's 100 million registered developers. So GitHub Copilot has, I think, the clearest demonstrated ROI of any AI tool in this category, especially for Microsoft, because not only does it generate revenue for you right now, it's also developers writing code 20 to 30 times faster in ways that show up directly in the shipping times for future products. So there's a lot of debate about how much more efficient AI is actually making people in terms of writing code. It's actually a thing that is the Real deal. And this also matters because developers often make the cloud infrastructure decisions at these big enterprises, so you benefit from it in many ways. So when a developer's entire workflow is on GitHub and Visual Studio, I think the path of least resistance, and we kind of mention it multiple times today, is also deploying in Azure $7.5 billion
- [83:16]
Sean O'Malley
for the world's most dominant coding platform, and which is also now the world's most adopted AI coding tool. And then also the primary channel through which Microsoft acquires developers who make cloud decisions. I mean, in retrospect, that just looks like maybe one of the best technology acquisitions of the last decade.
- [83:36]
Daniel Munga
It's one of the positive examples of Microsoft's acquisitions. And it's why I do give Satya Nadella Capital Allocation Instincts significant credit, even while asking some hard questions about the execution in recent years. Just overall, I think the perpetual license to subscription bet was correct, which obviously has been a long time ago, but still to some extent we gave Adobe CEO credit for that. Not only because it happened, but but also because it kind of shows the skill of adapting your business model to changes in the future, which is currently happening, then the Azure bet was obviously also correct. And then you have GitHub and you also have OpenAI, which doesn't sound like the best deal anymore if we look at it today. But honestly, three years ago AI was completely new. Nobody knew about it. And in 2019, investing in what a couple of years later is one of the biggest companies in the world. So that is a win.
- [84:28]
Sean O'Malley
All right, well, we've teased it enough. Let's get to the valuation. Is Microsoft our Google of 2026 or is it not as attractive as it might look at first glance?
- [84:39]
Daniel Munga
Well, I gotta say it's certainly way more complex, which is probably not a good thing. But in terms of valuation, I've divided my model into a base and a bear case. The base case assumes Microsoft kind of successfully navigates the AI transition on roughly the terms that management has described. So revenue compounds at about 17% annually through the next five years, which would be fiscal year 2030. And that might sound aggressive, but if you consider that Azure is still growing in the high 20s to low 30s and becoming a bigger part of the pie and also copilot adoption just improving from let's say 3.3% to a 10 to 12%. I mean, for that, obviously you wouldn't need it to be a much better product. But you know, on the install base that Microsoft has, and I believe they will find a way to bundle that. It's not like it's a heroic assumption at all. We still talk about five years out. So the key assumption in this model is on the margin side and basically means that free cash flow margins do recover modestly from today's depressed levels because of all the capex. So that means we go to somewhere in the mid-30s in five years time. And that basically means that the capex build out kind of peaks and that depreciation at that point stabilizes. And on that basis I think normalized free cash flow per share could be around $30. And if you then say, hey, well this is a company still one of the best in the world, probably deserves a 25 times exit multiple, then I would say that you could get a fair value today of around $500 per share. The company is complex. We don't fully understand it in all parts that it has ready for us. I would say a 20% margin of safety for all the stuff that we don't know is probably fair. And then you would end up at about $410, which is pretty much exactly where the stock is trading today. And you could say there's a bias between, you know, making the model and suddenly it's exactly the price it is today. But when I built it, the price of Microsoft was originally still $375. At that point the return that you could have expected was about 16%. At today's prices it's a bit closer to 14%.
- [86:41]
Sean O'Malley
Well, I feel like we've already done it, but shall we discuss the bear case in your valuation?
- [86:46]
Daniel Munga
We've certainly discussed the bear case and all of its qualitative factors. So in terms of numbers, I expect the top line growth to slow down slightly to about 13 to 14%. So it's not that I expect the company to just not grow anymore. But the bear case is mostly about what happens to the margin structure. If the commoditization thesis that we discuss, especially with AI is actually playing out so in detail, I do think that, you know, we could see margins compressed to about 35%. I'm talking about the operating margins here in five years time. And that mostly means, you know, you see a shift from this high margin software company to a more capital intensive infrastructure provider. And I think that margin trajectory reflects pretty much a world where the AI value chain economics that we've discussed at length today favor the model providers. Where Microsoft's platform as a service stickiness canva erodes as AI agents bypass that layer and where the infrastructure build out never fully earns its cost of capital. If you would then assume that we have an exit multiple maybe at about 20 times, which kind of makes sense because you have a lower margin business, it's also not growing as fast, then you would get to a fair value that's significantly lower somewhere in the 280s
- [87:57]
Sean O'Malley
for as interesting as today's episode has been, man, I've hardly ever been so confident about a company being in my too hard pile. Man, this just feels complicated and we talk a lot about using our consumer insights to shape how we invest. And honestly, I do not use Microsoft at all. Somehow I'm like an anomaly. I use Google's productivity suite personally and for work, I'm not a coder, I don't use GitHub, I don't use Copilot, I'm very loyal to Claude and Gemini, I have an iPad and not a Surface tablet. And actually I was really kind of raking my brain for this. My only connection to Microsoft that I can like really directly think of is my Xbox that I've had since college. So a lot of this was all very new to me, which makes it difficult to kind of digest everything. But then when you layer in how their massive capex is going to affect the income statement, while this huge profit pool in their productivity suite seems quite ripe for disruption, it is hard for me to get really excited about the company. I'm sure it's great, but I'd probably be much more excited to just add more to some of the businesses I already know, like Amazon, if I want more Mag7 exposure. And then with Alphabet too, we already have a significant amount of exposure to great cloud businesses in our intrinsic value portfolio and that really seems to be the most compelling part of the Microsoft story anyways. So it feels like taking on new risks, but not necessarily getting much more in return, except for perhaps a better valuation, at least on paper, compared to Alphabet. And so I don't know, maybe Microsoft will grow on me, but it's not so obviously a great opportunity to me that I need to invest in it over many of the other companies we follow for our intrinsic value portfolio.
- [89:48]
Daniel Munga
I agree, I think I was a bit surprised actually by how many reasonable bear cases there are for Microsoft. And we might get a bit of pushback here on this episode because I know there are a lot of people who love Microsoft, but when I look at companies like Amazon, I just find it hard to find as many bear cases. And I do believe that when we looked at Google about a year ago, there was certainly a lot of bad press. And still if you looked at the business model, it seemed easier to understand. It kind of seemed easier to see how this is actually completely mispriced by the market. Of course Amazon is a company that is trading at higher multiples than Microsoft is right now. But Microsoft is also on the deep value play either. So it's not that you would buy it because of its cheap valuation. So I do think that after looking into it and getting even more into this AI field and what exactly the economics of the cloud computing are and these circular investments with OpenAI, I do feel like it's going on the too hard pile and I feel like you might learn more over time. You might have some feedback in the comments of people who understand it way better, who think that they could explain it to us. If so, please do. But I do believe that currently it is on the two hard pile. Put it on a watch list, but not in our portfolio. And with that I would say I close it for today with a quote by Satya Nadella, of course, who was the CEO of Microsoft and he said our industry does not respect tradition. What it respects is innovation. And while there's a bear case to make for Microsoft, I'm pretty confident Microsoft will not go down because it missed out on innovating and kind of disrupting itself. So the question is whether it will be able to do that without disrupting its most profitable business before replacing it with a better one. I think only the future will tell if that's the case. And with that, see you all in the next episode.
- [91:38]
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