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In-Depth Research Analysis:
1 Executive Summary:
We believe that Microsoft has evolved beyond being merely a software or cloud computing leader; it is transforming into the core "operating system" and infrastructure provider of the Artificial Intelligence (AI) era. Its value is not only evident in the strong growth of its Azure cloud business and the commercial potential of its Copilot products but also in a structural advantage largely overlooked by the market: due to the application of Equity Method Accounting, the periodic losses of its partner, OpenAI, are creating a temporary, non-operational drag on Microsoft's current Earnings Per Share (EPS). However, this foreshadows a foreseeable and significant acceleration in earnings growth in the coming years.
Dual Growth Engines:
1)The Azure AI Platform: As the cornerstone of Microsoft's growth, the significance of Azure now transcends traditional cloud computing. By providing massive and exclusive computing power to its key partner, OpenAI, OpenAI itself has become one of Azure's most important and fastest-growing "super-clients." This not only generates direct and substantial revenue for Azure but also establishes it as the go-to platform that global AI developers cannot bypass.
2)The Copilot Ecosystem: AI services, represented by Copilot, are being deeply integrated into Microsoft's vast product portfolio (Microsoft 365, Windows, etc.). Leveraging its unparalleled distribution channel of hundreds of millions of users worldwide, Microsoft is unlocking a new, high-margin growth curve based on monthly subscription fees, marking a value leap from traditional SaaS to "SaaS+AI."
Investment Thesis:
An investment in Microsoft is fundamentally a bet on the core "picks-and-shovels" provider and "infrastructure operator" of the AI revolution. The deeper investment thesis is that we believe the market's judgment of its valuation may suffer from a "timing mismatch" error. Current mainstream valuation models have not fully digested the temporary suppression of earnings caused by its short-term accounting treatment. When investors see through this non-operational factor and recognize the potential for "built-in" earnings growth acceleration in the coming years, Microsoft's valuation will have significant room for a re-rating.
Key Risks:
We advise investors to pay close attention to three core risks:
1)High Valuation Pressure: The company's current valuation is at a historically high level, reflecting the market's optimistic expectations for AI. Any failure to meet performance expectations could trigger stock price volatility.
2)Antitrust Scrutiny: Global regulators (especially in the U.S. and E.U.) are closely monitoring Microsoft's partnership with OpenAI and its leadership position in the cloud market. Potential antitrust investigations represent a long-term shadow over the company.
3)Uncertainty in AI's Return on Investment (ROI): There remains uncertainty as to whether enterprise customers will be willing to pay for AI applications (like Copilot) on a large scale and over the long term, and whether the resulting productivity gains can be effectively quantified.
2 Deconstructing the Business Model: An AI-Driven Tech Empire
Microsoft's business model is undergoing a profound, AI-centric revolution. It is no longer a simple collection of three independent business segments but rather an AI-driven tech empire where each part synergizes with the others. AI acts as the neural network, tightly connecting Microsoft's vast cloud infrastructure, enterprise software, and personal computing endpoints to create unprecedented value and a formidable moat.
2.1 Intelligent Cloud - The Empire's Engine
The Intelligent Cloud segment, with Azure at its core, is Microsoft's most powerful growth engine.
Understanding Azure in Simple Terms: The "Public Utility" of the Digital World
You can think of Azure as a "public utility company" that powers the digital world. In the past, if a company wanted to develop software or build a website, it had to buy expensive physical servers, hard drives, and networking equipment, and then hire a dedicated team to maintain it all. This was a costly and inefficient process.
Azure changes this completely. It allows any business—from a two-person startup to a Fortune 500 corporation—to rent computing power, storage space, databases, and various advanced services from Microsoft's massive, state-of-the-art data centers via the internet. Just as we use electricity, businesses only pay for the computing resources they actually consume, freeing them from huge upfront investments and ongoing maintenance costs. This enables companies to innovate and scale their operations more flexibly, quickly, and economically.
Azure OpenAI Service: From "General Power" to "Nuclear Power"
If traditional Azure provided "general power," then in the AI era, Azure has equipped itself with a "nuclear reactor" through its strategic partnership with OpenAI. Microsoft is not simply reselling OpenAI's technology; it is deeply integrating it into its own platform to offer the "Azure OpenAI Service." This service allows enterprises to access the world's most advanced large language models, including GPT-4, within Azure's secure, compliant, and trusted environment. For enterprise clients who prioritize data security and stability, this is practically the only choice, giving Azure a massive competitive advantage.
OpenAI: From Partner to "Super-Client"
The Microsoft-OpenAI relationship is a two-way street. On one hand, Microsoft is an investor and technology provider; on the other, OpenAI has become one of Azure's most significant and fastest-growing "super-clients." This symbiotic relationship is manifested in several ways:
1)Compute Consumption: Training and running its models (like ChatGPT) requires OpenAI to consume enormous amounts of GPU computing power, the vast majority of which is supplied by Azure. This directly translates into tangible, high-growth cloud service revenue for Azure.
2)Revenue Sharing and Customer Funneling: Microsoft sells API access to its vast enterprise customer base through the Azure OpenAI Service, earning a share of the revenue. More importantly, this creates a powerful "customer funneling" effect: any company wishing to leverage OpenAI's advanced models is naturally guided to the Azure platform. This, in turn, drives sales of other Azure services like databases, networking, and security, significantly increasing customer stickiness.
3)Evidence in Performance Commitments: A review of the company's public financial disclosures reveals a significant increase in its Remaining Performance Obligation (RPO) in recent years. This growth is backed by long-term, multi-billion-dollar Azure consumption commitments from major AI partners, providing a high degree of certainty for Azure's future revenue growth.
2.2 Productivity & Business Processes - The Empire's Cash Cow
This segment is Microsoft's traditional "cash cow," centered around Microsoft 365 (formerly Office 365) and Dynamics 365, boasting hundreds of millions of highly loyal enterprise users. The infusion of AI is now causing this cash cow to produce "gold."
Copilot: High-Margin, "Purely Incremental" Revenue
The launch of Copilot for Microsoft 365 is the masterstroke of Microsoft's AI commercialization strategy. Its pricing model—an additional $30 per user, per month on top of existing subscriptions—is a classic. This price point is nearly equivalent to a mid-tier Microsoft 365 subscription itself, powerfully demonstrating Microsoft's confidence in the value of its AI productivity tools.
For investors, the appeal of this revenue stream lies in its "purely incremental" and "high-margin" nature. Microsoft needs to spend very little on additional marketing to promote Copilot to its massive existing user base. This is a classic case of leveraging an asymmetric advantage, using its unparalleled distribution channel to directly monetize AI capabilities and unlock an exciting new growth frontier for this mature SaaS business.
2.3 More Personal Computing - The Empire's Moat
This segment, once considered "traditional" or even "slow-growing," has also been reborn with the empowerment of AI, becoming a critical moat that fortifies the empire's domain.
The AI-ification of Windows: The full integration of "Copilot in Windows" and the launch of AI PCs (with built-in NPUs) in partnership with chip manufacturers are redefining the personal computer. The PC is no longer just a tool for running software but an intelligent endpoint with local AI computing capabilities. This is not only expected to stimulate a new hardware replacement cycle but also elevates the strategic importance of the Windows operating system to a new level.
The AI Future of the Gaming Empire: Following the acquisition of Activision Blizzard, Microsoft has become a global gaming titan on par with Sony and Tencent. The potential for AI in gaming is vast, with applications like intelligent NPCs, automated game testing, and personalized content generation poised to dramatically improve development efficiency and player experience. Its massive portfolio of gaming IP and large user base gives Microsoft a head start in the future "metaverse" or next-generation interactive entertainment platforms.
The Renaissance of the Search Business: Integrating an AI chatbot into the Bing search engine was Microsoft's first shot fired in the AI commercialization war. While it did not dethrone Google, the move successfully revitalized market competition, forced its rival into a hasty response, and won Bing valuable market share and user attention. It brought a marginal business back to the center stage of technological innovation.
3 The Core Investment Thesis: The Profit Accelerator "Hidden" by Accounting Principles
We believe that the current market valuation of Microsoft, while seemingly high, does not fully reflect its intrinsic, structural earnings growth potential. The core reason lies in a critical but easily overlooked accounting treatment that temporarily "suppresses" Microsoft's reported Earnings Per Share (EPS), yet simultaneously creates a foreseeable "profit catapult" for the coming years.
3.1 The Equity Method Accounting Mystery: Why Do OpenAI's Losses Impact Microsoft's Profits?
To understand this thesis, we must first grasp an accounting concept: The Equity Method.
The Basic Principle: When a company holds significant influence over another company (typically defined as a 20%-50% ownership stake) but does not have outright control, it must use the equity method to account for that investment. Microsoft's 49% stake in OpenAI's for-profit entity perfectly meets this criterion.
The Practical Impact: Under the equity method, Microsoft must recognize a pro-rata share (49%) of OpenAI's net income or net loss on its own income statement.
The formula can be simplified as: Microsoft's Reported Net Income = Net Income from Microsoft's Core Business +/- (OpenAI's Net Income/Loss × 49%)
The Current Situation: OpenAI is currently in a massive strategic investment phase. Its R&D costs (developing next-generation models) and compute costs (the enormous fees paid to Azure) far exceed its current revenue, placing it in a state of strategic loss. According to the equity method, Microsoft must recognize 49% of these losses in its financial statements.
The Conclusion: This creates an "accounting illusion": Microsoft's reported EPS is being artificially and non-operationally dragged down. This loss does not stem from any weakness in Microsoft's own core businesses (like Azure or Office) and it doesn't even affect Microsoft's cash flow. However, it materially impacts the final reported numbers, influencing valuation models that rely on surface-level Price-to-Earnings (P/E) ratios.
3.2 Why Are OpenAI's Losses "High-Quality" Losses?
Not all losses are created equal. We argue that OpenAI's losses are strategic, "high-quality" losses because they are laying the foundation for a long-term, dominant market position. More importantly, a significant portion of these losses is actually an "internal transfer of value" within the Microsoft empire.
1)Investing in the Future: OpenAI's losses are primarily directed toward two areas: first, attracting top global AI talent for cutting-edge research, and second, paying the astronomical compute costs required to train and run large-scale models. This is a necessary investment to build the technological moat for the next generation of AI.
2)Moving Money from One Pocket to the Other: The largest recipient of OpenAI's massive compute payments is Microsoft's Azure division. This means that a large part of the "expense" on OpenAI's income statement is converted directly into "revenue" for Microsoft's Azure segment. While Microsoft's consolidated profit is reduced by OpenAI's loss under the equity method, the revenue and profit of its core growth engine—Azure—are actually growing as a direct result. This is a closed-loop value transfer completed within the Microsoft ecosystem.
3.3 The Inflection Point and the EPS Catapult: The Shift from Drag to Engine
This accounting "drag" is temporary, but its future reversal will be dramatic. We foresee a clear profitability inflection point:
Phase 1 (Current): The Drag Phase. OpenAI's losses suppress Microsoft's reported EPS, potentially leading the market to assign it a more conservative valuation.
Phase 2 (Next 1-2 Years): The Drag Reduction Phase. As OpenAI's commercial products, such as ChatGPT Enterprise and API usage, gain rapid adoption, its revenue will grow substantially, and its losses will narrow quickly. This means the negative impact on Microsoft's EPS will diminish each quarter. The mere disappearance of this "drag" will make Microsoft's EPS growth appear faster than its actual business growth.
Phase 3 (Next 2-3 Years): The Contribution Phase. When OpenAI achieves profitability, the situation will fundamentally reverse. According to the equity method, Microsoft will begin recognizing 49% of OpenAI's net profit on its income statement.
At that point, Microsoft's EPS growth will be driven by two powerful forces, creating a formidable "catapult effect":
1)The steady growth of its own core businesses (Azure + Copilot).
2)A significant profit contribution from OpenAI (a massive swing from a negative to a positive).
When this inflection point arrives, the market will witness a Microsoft whose EPS growth suddenly "accelerates." Investors and models accustomed to extrapolating based on historical growth rates will be forced to re-evaluate Microsoft's growth prospects, triggering a stock re-rating. Our investment thesis is to identify this hidden value and position ourselves before this re-assessment occurs.
4 Risks and Mitigating Factors
While we are exceptionally optimistic about Microsoft's AI strategy and its future profitability, any prudent investment decision must be grounded in a clear understanding of the potential risks. We have identified the following key risks and analyzed Microsoft's corresponding "cushions" or mitigation strategies.
Risk 1: The Intensifying AI "Arms Race"
Risk Description: Microsoft is not the only player. The entire technology industry is engaged in an unprecedented AI "arms race."
1)Google: As Microsoft's most direct and formidable competitor, Google possesses its own top-tier AI research lab (DeepMind), a powerful cloud platform (Google Cloud), a productivity suite rivaling Office 365 (Workspace), and the world's largest data source (Search). Its Gemini family of models is on par with GPT-4 in performance, posing a comprehensive challenge.
2)Amazon (Amazon Web Services): As the global leader in cloud computing, AWS will not stand by and watch Azure erode its market share with AI. AWS is actively building its own AI ecosystem by investing in Anthropic (developer of the Claude models) and offering a diverse selection of AI models on its Bedrock platform.
3)Meta Platforms: By open-sourcing its high-performance Llama family of models, Meta is driving the "commoditization" of AI technology, which could, in the long term, weaken the pricing power of proprietary models like GPT-4.
Mitigating Factor: Microsoft's core advantage lies in its unparalleled distribution channels and enterprise customer base. The ability to embed Copilot directly into Word, Excel, and Teams—applications used by hundreds of millions of people daily—is a "last-mile" reach that is difficult for Google and Amazon to replicate. For a Chief Information Officer (CIO), the decision-making process and integration cost of adding an AI feature to their already deeply entrenched Microsoft tech stack are far lower than introducing an entirely new vendor.
Risk 2: Regulatory and Antitrust Scrutiny
Risk Description: The "intimate" partnership between Microsoft and OpenAI has already attracted significant attention from global regulators. Antitrust authorities in the United States, the United Kingdom, and the European Union have launched reviews of this investment to determine if it constitutes a de facto acquisition that could harm market competition. This poses the most direct potential threat to our core investment thesis. If regulators were to force the two parties to "unbundle" or alter the terms of their partnership, the synergies described earlier would be severely compromised.
Mitigating Factor: Firstly, Microsoft possesses one of the world's most sophisticated legal and government relations teams, with decades of experience navigating regulatory challenges. Secondly, structuring the deal as a "strategic investment and partnership" rather than a "direct acquisition" was a deliberate legal arrangement designed to avoid the strictest levels of scrutiny. Lastly, Microsoft is actively incorporating other AI models (like Meta's Llama) into Azure, presenting an "open platform" posture to demonstrate to regulators that it is not attempting to monopolize the market.
Risk 3: Execution and Adoption Risk for Copilot
Risk Description: The $30 per user per month price point is a bold gamble. Whether enterprises will be willing to purchase Copilot at scale for their employees ultimately depends on its ability to deliver a quantifiable boost in productivity. If feedback from early adopters is lackluster, or if companies find the return on investment (ROI) to be unclear, the adoption rate could be much slower than the market's optimistic expectations, thereby impacting the realization of this "purely incremental" revenue.
Mitigating Factor: Under the leadership of CEO Satya Nadella, Microsoft has demonstrated exceptional long-term strategic execution. The company has adopted a phased, customer-segmented rollout strategy, allowing it to continuously iterate and optimize the product based on market feedback. More importantly, Microsoft's vast enterprise user base provides an enormous margin for error: even if only 10% of Microsoft 365 commercial users adopt Copilot in the coming years, it would be sufficient to generate tens of billions of dollars in annual revenue.
Risk 4: Rapid Iteration of Open-Source Models
Risk Description: High-performance open-source large language models, led by Meta's Llama and France's Mistral AI, are rising rapidly. Their performance is quickly catching up to closed-source leading models, but at a lower cost. This could lead to the rapid "commoditization" of AI capabilities, thereby eroding the profit margins and pricing power of the Azure OpenAI Service.
Mitigating Factor: Microsoft has adopted an "embrace and include" or "sell the shovels" strategy in response. Azure not only offers exclusive OpenAI models but also actively integrates mainstream open-source models onto its platform. Microsoft's logic is that regardless of which model developers and enterprises choose, they will need a powerful, secure, and reliable cloud platform to run, host, and fine-tune them. As long as that workload runs on Azure, Microsoft wins. For the majority of enterprise customers, using a secure, managed, and technically supported version of an open-source model provided by Azure is far more convenient and less risky than a do-it-yourself deployment, creating yet another layer to Microsoft's moat.
5: Valuation Analysis and Conclusion
Traditional Price-to-Earnings (P/E) valuation methods, unable to see through the earnings illusion created by "equity method accounting," may not fully capture the true value of Microsoft. To more comprehensively assess this technology empire, which is composed of multiple powerful business segments, we employ a Sum-of-the-Parts (SOTP) analysis. This, combined with our judgment on the future value of OpenAI, helps form a composite valuation perspective.
5.1 Sum-of-the-Parts (SOTP) Analysis
We break down Microsoft's core business into three segments and discuss the appropriate valuation logic for each, based on their respective growth prospects, profit margins, and market positions.
1. Intelligent Cloud: The Crown Jewel of the Empire
Business Characteristics: High growth, high-margin, and the core AI-driven engine. Azure is the biggest infrastructure beneficiary of this technological revolution.
Valuation Logic: Its market position and growth potential would typically warrant a valuation consideration comparable to that of top-tier, high-growth SaaS and cloud computing companies.
2. Productivity & Business Processes: The Upgraded Cash Cow
Business Characteristics: A rock-solid market position, extremely high user stickiness, and stable cash flow. The launch of Copilot has injected a new, high-margin growth driver into this segment.
Valuation Logic: As a mature yet innovative SaaS business, its valuation would typically be higher than that of traditional software companies, though perhaps slightly below the highest-growth cloud segment.
3. More Personal Computing: The Solid Foundation
Business Characteristics: Relatively mature and slower-growing, but the AI-integration into Windows and the consolidation of the gaming business (Activision Blizzard) provide new points of interest and growth potential.
Valuation Logic: Its valuation would typically be benchmarked against mature technology hardware or large gaming companies.
5.2 OpenAI: A Significant Value Variable
Most critically, the SOTP analysis framework described above does not explicitly include any direct equity value that may be contributed by OpenAI itself.
In any valuation model, how to assess Microsoft's 49% stake in OpenAI is a central issue. A conservative view might only consider its transition from being a drag on Microsoft's EPS to a contributor. A more forward-looking perspective, however, would attempt to assess the long-term value of OpenAI as a standalone entity and factor in Microsoft's ownership percentage.
This means that when valuing Microsoft, investors are essentially faced with a significant variable: the future success of OpenAI could bring incremental value to Microsoft far exceeding the growth of its core businesses. This creates an attractive "asymmetric" possibility.
5.3 Valuation Conclusion
In summary, we are at a critical juncture of a technological paradigm shift, and Microsoft is undoubtedly one of the most comprehensively positioned participants in this AI revolution. It not only possesses the infrastructure to drive the revolution (Azure) and the application channels to commercialize its results at scale (Copilot), but also the moats to solidify its ecosystem (Windows + Gaming).
More notably, due to the specific impact of equity method accounting, its current reported earnings may not fully reflect the true performance of its core business or its future earnings potential. When OpenAI's financial situation improves and this accounting "drag" transforms into a "boost," Microsoft's reported earnings per share (EPS) growth trajectory could experience a significant inflection point of acceleration.
Therefore, any valuation of Microsoft should go beyond traditional P/E analysis based on historical data. It must involve a deep understanding of the intrinsic value of its business segments and a careful assessment of its unique strategic positioning in the AI domain—especially the distinct risks and opportunities arising from its deep integration with OpenAI.
Disclaimer:
The Information presented above is for information purposes only, which shall not be intended as and does not constitute an offer to sell or solicitation for an offer to buy any securities or financial instrument or any advice or recommendation with respect to such securities or other financial instruments or investments. When making a decision about your investments, you should seek the advice of a professional financial adviser and carefully consider whether such investments are suitable for you in light of your own experience, financial position and investment objectives. The firm and its analysts do not have any material interest or conflict of interest with any stocks mentioned in this report.
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