Category: Cloud Software

Microsoft Fiscal Q2 Earnings: Accelerating Growth, AI in the Spotlight

Posted on by io-fund

Microsoft kicks off Big Tech’s earnings alongside AMD and Alphabet, with AI in the spotlight as the company posted a sizable beat last quarter while seeing “higher-than-expected AI consumption.” Revenue and EPS estimates have inched higher, with the current revenue estimate of $61.1 billion slightly above management’s guide for $60.9 billion, highlighting the optimism the Street has on AI-related tailwinds.

Azure and Copilot will be closely watched, as Intelligent Cloud drove $850M of Microsoft’s ~$2 billion beat in fiscal Q1 due to AI tailwinds, while analysts are optimistic on Copilot creating a new stream of revenue over the next few fiscal years. Microsoft has been a big investor in scaling its data center and AI capabilities, and the Street is looking for these investments to bear fruits in Q2.

Notably, keep an eye out for a PC super cycle which could occur in H2 2024. Microsoft will be a clear beneficiary of this given Windows is expected to get its most important upgrade in many years (decades?) with many AI features.

Revenue and EPS:

Microsoft is currently expected to report $2.77 EPS on $61.13 billion in revenue, representing 19.3% and 15.9% YoY growth respectively. This would mark a significant acceleration in revenue growth, from 8.3% in fiscal Q4 to 12.8% in fiscal Q1. To put this in perspective, revenue growth estimates for fiscal Q2 were just 10.6% in October, with Q1’s beat and guide leading to a 530 bp acceleration.

Revenue growth rates are expected to hover around 15% through fiscal Q1 2025 as Microsoft captures AI related growth in Azure and Copilot. However, Microsoft’s guide for operating margins look to be weighing on EPS estimates, which are pointing to growth decelerating to the low single-digit range in fiscal Q4.

Margins:

Fiscal Q1 saw Microsoft post strong operating margin expansion, rising 440 bp from 43.2% to 47.6%, driven by a 450 bp margin expansion in Intelligent Cloud. However, Microsoft guided for operating margin of 42.4% in fiscal Q2 and flat for the full year.

The concern here is that margins continue to deteriorate through the end of the fiscal year. Last quarter’s guide for flat YoY operating margin suggests FY24’s margin will hover around 41.8%, or a ~320 bp decline over the next two quarters. Management explained that the flat guide “speaks to the pace at which we're delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see.”

There may be some room for margin expansion in Intelligent Cloud should Microsoft remain disciplined within its spending as it progresses with Azure’s AI transition. There is potential upside to operating margins on better-than-expected integration of the Activision acquisition and Microsoft’s continued efforts to improve Azure and Microsoft 365 gross margins, given recent Copilot subscription launches.

What to Watch: Azure and Copilot

Microsoft will give the first insight into Copilot’s revenue this quarter, after launching commercial subscriptions on November 1 for its AI assistant. We highlighted previously that Copilot was among one of six levers that could drive an additional $100 billion in revenue for Microsoft by 2027.

Microsoft has ~160 million users on 365 Enterprise plans, meaning that it needs just 18% adoption of Copilot to reach a $10 billion annual revenue run rate. For the consumer Copilot, priced at $20/month compared to $30/month for enterprises, just over 5% adoption from its ~77 million user base is needed to reach a $1 billion revenue run rate.

Analysts are similarly bullish on Copilot, with Citi highlighting how “a 5% adoption rate by its 77M customers using Microsoft 365 could add $925 million in revenue by fiscal year 2025. An adoption rate of 15% could add $2.7 billion in sales.”

The immediate impact of Copilot is likely to be minimal to start given the timing of the launch, while any clues as to the initial adoption rate among enterprises will be watched closely.

Microsoft’s predominant stream of AI-related revenues at the moment stems from Azure, as it is powering a handful of the largest LLMs and AI assistants on the market, from OpenAI’s ChatGPT to Meta’s Llama and Llama 2 to Microsoft’s own Bing Copilot.

A consumption pricing model offers tailwinds to Azure, as a majority of OpenAI’s APIs for ChatGPT were all new workloads for Azure over the last twelve months. In addition, Azure Open AI Services has been adopted by 18,000 organizations, which allows companies to use OpenAI’s APIs for new development purposes. Essentially, OpenAI is helping drive growth for Azure even if startups or companies are not direct Azure customers.

Q3 saw Azure’s growth inflect whereas Google Cloud’s growth decelerated, reflecting the benefits of this consumption pricing model. Microsoft’s CFO Amy Hood explained last quarter that Azure’s “growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services as well as slightly higher-than-expected growth in our per-user business.”

What will be key for Microsoft is a sequential acceleration in Azure in fiscal Q2 – this confirms the bull thesis that AI is driving stronger revenue growth in the early innings of monetization while rivals AWS and Google falter, and the long-term thesis that AI will drive tens of billions in additional revenue. However, if Azure decelerates even slightly, such as by 1 percentage point QoQ, Microsoft’s stretched valuation leaves it vulnerable to the downside with no room for error.

Capex:

Capex commentary will be watched closely as well, given that Microsoft is estimated to have devoted 13% of Capex to AI in 2023, the most among the top cloud service providers. CFO Amy Hood said last quarter that “Capital expenditures, including finance leases were $11.2 billion to support cloud demand, including investments to scale our AI infrastructure. … We expect capital expenditures to increase sequentially on a dollar basis, driven by investments in our cloud and AI infrastructure. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout.”

Capex here is important as it not only allows Microsoft to rapidly deploy and scale its AI infrastructure, but it opens the door for further leverage in the future. Management explained that for “every capital dollar we spend, if we optimize revenue against it, we will have great leverage. Because wherever demand shows up in the layers, whether it's at the SaaS layer, whether it's at the infrastructure lower, whether it's for training workloads, we're able to quickly put our infrastructure to work generating revenue.”

Being able to meet high consumption and demand for AI regardless of where it is in the stack serves as a crucial tailwind in that it should allow Microsoft to fare better than its peers whenever budgets are optimized, for short or extended periods of time. To do so, Microsoft has to spend quite aggressively – its Capex to revenue ratio is nearing the highest level in 33 years, at 0.145 compared to a peak at 0.148 in March 1991.

Management may not provide a concrete capex number this quarter, given the commentary last quarter was fairly vague in terms of sequential increases. What’s critical for the company will be showing how this elevated capex spend can flow directly through to the cloud and Azure.

Valuation:

The primary risk here is that Microsoft’s valuation is back at peak levels, opening up downside risk should it show any hint of weakness, whether that surfaces in margins, EPS forecasts, Azure growth, or overall cloud revenue.

Microsoft is trading at all-time highs just below $410 after rallying more than 11% since January 5. Shares are trading at a PE of 39.7x and a forward PE of 36.5x, levels that it has historically failed to hold, with the most notable being 2021’s top. Shares are also trading at a large premium to its 5-year median PE of 31.6x.

A look at sales-based valuation metrics shows a similar trend. Microsoft is trading at 14x sales and 12.5x forward sales, both far above the 5-year median of 10.9x. Microsoft historically has struggled to hold a forward PS above 12.9x, suggesting that shares are closing in on a top if the report is nothing less than stellar.

Conclusion:

Microsoft kicks off a jam-packed week for Big Tech and AI, with the focus likely to be primarily on initial revenue generation for Copilot and any outlook provided (if any) as well as Azure’s growth and if AI can drive a meaningful sequential increase in growth. Microsoft is demonstrating that it has multiple levers within its product suite to capture AI growth and multiple outlets to capture AI growth via Azure. Fiscal Q2 is expected to start a multiple quarter streak with revenue growth near the 15% range, but EPS estimates raise concerns that margins may weigh on the bottom line. Microsoft’s valuation leaves little room for error, with shares at peak valuations and hard-to-hold levels historically. Yet, AI has been a powerful trend – let’s see if Microsoft’s AI commentary can push the stock higher, or perhaps Microsoft will instead be a reminder of just how far the Mag 7 has come in price in a brief period of time.

Recommended Reading:

Microsoft Fiscal Q2 Earnings: Accelerating Growth, AI in the Spotlight

Posted on by io-fund

Microsoft kicks off Big Tech’s earnings alongside AMD and Alphabet, with AI in the spotlight as the company posted a sizable beat last quarter while seeing “higher-than-expected AI consumption.” Revenue and EPS estimates have inched higher, with the current revenue estimate of $61.1 billion slightly above management’s guide for $60.9 billion, highlighting the optimism the Street has on AI-related tailwinds.

Azure and Copilot will be closely watched, as Intelligent Cloud drove $850M of Microsoft’s ~$2 billion beat in fiscal Q1 due to AI tailwinds, while analysts are optimistic on Copilot creating a new stream of revenue over the next few fiscal years. Microsoft has been a big investor in scaling its data center and AI capabilities, and the Street is looking for these investments to bear fruits in Q2.

Notably, as stated in our AMD write-up, keep an eye out for a PC super cycle which could occur in H2 2024. Microsoft will be a clear beneficiary of this given Windows is expected to get its most important upgrade in many years (decades?) with many AI features.

Revenue and EPS:

Microsoft is currently expected to report $2.77 EPS on $61.13 billion in revenue, representing 19.3% and 15.9% YoY growth respectively. This would mark a significant acceleration in revenue growth, from 8.3% in fiscal Q4 to 12.8% in fiscal Q1. To put this in perspective, revenue growth estimates for fiscal Q2 were just 10.6% in October, with Q1’s beat and guide leading to a 530 bp acceleration.

Revenue growth rates are expected to hover around 15% through fiscal Q1 2025 as Microsoft captures AI related growth in Azure and Copilot. However, Microsoft’s guide for operating margins look to be weighing on EPS estimates, which are pointing to growth decelerating to the low single-digit range in fiscal Q4.

Margins:

Fiscal Q1 saw Microsoft post strong operating margin expansion, rising 440 bp from 43.2% to 47.6%, driven by a 450 bp margin expansion in Intelligent Cloud. However, Microsoft guided for operating margin of 42.4% in fiscal Q2 and flat for the full year.

The concern here is that margins continue to deteriorate through the end of the fiscal year. Last quarter’s guide for flat YoY operating margin suggests FY24’s margin will hover around 41.8%, or a ~320 bp decline over the next two quarters. Management explained that the flat guide “speaks to the pace at which we're delivering AI revenue with the increasing cost expense and capital investment ahead with the demand we see.”

There may be some room for margin expansion in Intelligent Cloud should Microsoft remain disciplined within its spending as it progresses with Azure’s AI transition. There is potential upside to operating margins on better-than-expected integration of the Activision acquisition and Microsoft’s continued efforts to improve Azure and Microsoft 365 gross margins, given recent Copilot subscription launches.

What to Watch: Azure and Copilot

Microsoft will give the first insight into Copilot’s revenue this quarter, after launching commercial subscriptions on November 1 for its AI assistant. We highlighted previously that Copilot was among one of six levers that could drive an additional $100 billion in revenue for Microsoft by 2027.

Microsoft has ~160 million users on 365 Enterprise plans, meaning that it needs just 18% adoption of Copilot to reach a $10 billion annual revenue run rate. For the consumer Copilot, priced at $20/month compared to $30/month for enterprises, just over 5% adoption from its ~77 million user base is needed to reach a $1 billion revenue run rate.

Analysts are similarly bullish on Copilot, with Citi highlighting how “a 5% adoption rate by its 77M customers using Microsoft 365 could add $925 million in revenue by fiscal year 2025. An adoption rate of 15% could add $2.7 billion in sales.”

The immediate impact of Copilot is likely to be minimal to start given the timing of the launch, while any clues as to the initial adoption rate among enterprises will be watched closely.

Microsoft’s predominant stream of AI-related revenues at the moment stems from Azure, as it is powering a handful of the largest LLMs and AI assistants on the market, from OpenAI’s ChatGPT to Meta’s Llama and Llama 2 to Microsoft’s own Bing Copilot.

A consumption pricing model offers tailwinds to Azure, as a majority of OpenAI’s APIs for ChatGPT were all new workloads for Azure over the last twelve months. In addition, Azure Open AI Services has been adopted by 18,000 organizations, which allows companies to use OpenAI’s APIs for new development purposes. Essentially, OpenAI is helping drive growth for Azure even if startups or companies are not direct Azure customers.

Q3 saw Azure’s growth inflect whereas Google Cloud’s growth decelerated, reflecting the benefits of this consumption pricing model. Microsoft’s CFO Amy Hood explained last quarter that Azure’s “growth was ahead of expectations, primarily driven by increased GPU capacity and better-than-expected GPU utilization of our AI services as well as slightly higher-than-expected growth in our per-user business.”

What will be key for Microsoft is a sequential acceleration in Azure in fiscal Q2 – this confirms the bull thesis that AI is driving stronger revenue growth in the early innings of monetization while rivals AWS and Google falter, and the long-term thesis that AI will drive tens of billions in additional revenue. However, if Azure decelerates even slightly, such as by 1 percentage point QoQ, Microsoft’s stretched valuation leaves it vulnerable to the downside with no room for error.

Capex:

Capex commentary will be watched closely as well, given that Microsoft is estimated to have devoted 13% of Capex to AI in 2023, the most among the top cloud service providers. CFO Amy Hood said last quarter that “Capital expenditures, including finance leases were $11.2 billion to support cloud demand, including investments to scale our AI infrastructure. … We expect capital expenditures to increase sequentially on a dollar basis, driven by investments in our cloud and AI infrastructure. As a reminder, there can be normal quarterly spend variability in the timing of our cloud infrastructure buildout.”

Capex here is important as it not only allows Microsoft to rapidly deploy and scale its AI infrastructure, but it opens the door for further leverage in the future. Management explained that for “every capital dollar we spend, if we optimize revenue against it, we will have great leverage. Because wherever demand shows up in the layers, whether it's at the SaaS layer, whether it's at the infrastructure lower, whether it's for training workloads, we're able to quickly put our infrastructure to work generating revenue.”

Being able to meet high consumption and demand for AI regardless of where it is in the stack serves as a crucial tailwind in that it should allow Microsoft to fare better than its peers whenever budgets are optimized, for short or extended periods of time. To do so, Microsoft has to spend quite aggressively – its Capex to revenue ratio is nearing the highest level in 33 years, at 0.145 compared to a peak at 0.148 in March 1991.

Management may not provide a concrete capex number this quarter, given the commentary last quarter was fairly vague in terms of sequential increases. What’s critical for the company will be showing how this elevated capex spend can flow directly through to the cloud and Azure.

Valuation:

The primary risk here is that Microsoft’s valuation is back at peak levels, opening up downside risk should it show any hint of weakness, whether that surfaces in margins, EPS forecasts, Azure growth, or overall cloud revenue.

Microsoft is trading at all-time highs just below $410 after rallying more than 11% since January 5. Shares are trading at a PE of 39.7x and a forward PE of 36.5x, levels that it has historically failed to hold, with the most notable being 2021’s top. Shares are also trading at a large premium to its 5-year median PE of 31.6x.

A look at sales-based valuation metrics shows a similar trend. Microsoft is trading at 14x sales and 12.5x forward sales, both far above the 5-year median of 10.9x. Microsoft historically has struggled to hold a forward PS above 12.9x, suggesting that shares are closing in on a top if the report is nothing less than stellar.

Conclusion:

Microsoft kicks off a jam-packed week for Big Tech and AI, with the focus likely to be primarily on initial revenue generation for Copilot and any outlook provided (if any) as well as Azure’s growth and if AI can drive a meaningful sequential increase in growth. Microsoft is demonstrating that it has multiple levers within its product suite to capture AI growth and multiple outlets to capture AI growth via Azure. Fiscal Q2 is expected to start a multiple quarter streak with revenue growth near the 15% range, but EPS estimates raise concerns that margins may weigh on the bottom line. Microsoft’s valuation leaves little room for error, with shares at peak valuations and hard-to-hold levels historically. Yet, AI has been a powerful trend – let’s see if Microsoft’s AI commentary can push the stock higher, or perhaps Microsoft will instead be a reminder of just how far the Mag 7 has come in price in a brief period of time.

Recommended Reading:

Palantir, Three Other Cloud Stocks Poised For An Acceleration In 2024

Posted on by io-fund

This article was originally published on Forbes on Dec 14, 2023,10:42pm ESTForbes Forbes on Dec 14, 2023,10:42pm EST

Cloud stocks have been a mixed bag for investors heading into the end of the year, as a handful of names — Confluent, Sprinklr, HashiCorp, Bill, Paycom — plunged following their earnings reports with growth set to slow, while others — Datadog, Elastic, Salesforce – soared on renewed optimism about AI prospects.

Overall, cloud has lagged broader tech’s rally this year, and on a 3-year basis, returns are still negative, compared to a 27.4% gain for the QQQ. Many cloud darlings in 2020 and 2021 remain far below those highs – take Fastly, for example, where quarterly growth has slowed from the 40% range to the teens, with shares nearly (-80%) lower.

Cloud Darling Chart

Source: I/O FUND

2023 was a stock picker’s market, and 2024 likely will be as well, with revenue growth rates for a majority of the sector set to slow. Only a few cloud stocks are expected to see revenue growth rates accelerate in 2024. We detail for you the four stocks set to accelerate below.

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Palantir

Palantir is one of the Street’s AI favorites this year with a 179% YTD return. The company is exhibiting multiple signs of acceleration heading into 2024 with an improved fundamental backdrop driven by increasing AI demand. Palantir’s Artificial Intelligence Platform (AIP) is driving a significant acceleration in its US commercial business, while underlying metrics and the bottom line are rapidly improving: Palantir posted its first GAAP profitable quarter in February and has since reported four consecutive GAAP profitable quarters.

Customer and US commercial customer growth remains solid, growing 34% and 37% YoY respectively in Q3. CRO Ryan Thomas noted that the US commercial business accelerated in Q3, and excluding strategic commercial contracts, it grew 52% year-over-year and 19% sequentially. Total contract value in the segment increased 55% year-over-year on a dollar-weighted duration basis, with an “acceleration of larger deals and shorter times to conversion and expansion.” He attributed this growth partially to the AI Platform, as the “rapid expansion of AIP at both our existing and new customers, and the impact it is having on their operations is nothing short of remarkable.”

The AI Platform’s growth since its launch in June has also been remarkably strong, with Palantir nearly tripling the number of users in the past quarter, with over 300 organizations using the product in 5 months. Palantir’s profitability is allowing it to continue to “more aggressively invest” in the AI Platform without sacrificing margins, a key differentiator from a majority of cloud AI plays, who are investing in growth at the expense of margins.

Fundamentally, Palantir is becoming stronger. GAAP gross margin expanded above 80% for the first time in Q3, GAAP operating margin has expanded to 7.2%, and GAAP net margin has risen to 12.8%. Palantir’s EBITDA margin also reached 16% in Q3, its first quarter with a double-digit positive margin, while adjusted free cash flow margin reached 25%. Margins have expanded sequentially in both Q2 and Q3, so the next hurdle will be showing further expansion in Q4 to set up for an increasingly positive trajectory in 2024.

Palantir Margin Charts

Source: I/O FUND

Revenue growth is poised to accelerate in Q4 and through 2024, boosted by AI demand, a reacceleration in Palantir’s US government segment, and continued strength in the US commercial segment stemming from the Artificial Intelligence Platform. Palantir is currently projected to report 18.5% YoY growth in revenues in Q4, the highest in five quarters, pulling 2023’s full-year revenue growth rate up to a projected 16.5%. 2024 is expected to see an acceleration, with current projections pointing to a 320 bp acceleration in Palantir’s revenue growth rate to 19.7% YoY.

Palantir Quarterly Revenue Growth, YoY

Source: SeekingAlpha

Palantir’s underlying metrics support the revenue reacceleration story, but the stock is by no means cheap at 14.2x 2024 EV/revenue and approximately 52x 2024 operating cash flow. Palantir also noted in Q3 that its net dollar retention rate was 107%, with adverse impacts from its European commercial business. This presents a risk that a land-and-expand strategy places more emphasis on signing more customer deals each quarter, and a slowdown in customer additions raises the risk that the expected revenue acceleration won’t pan out as projected.

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Shift4 Payments

Payments processing firm Shift4 Payments is not a traditional cloud stock, but it has seen significant momentum within its cloud product, SkyTab, alongside positive momentum in a land-and-expand model for its software offerings. Shift4’s recent M&A activity with Appetize and Finaro are expected to significantly contribute to revenue and EBITDA, playing a role in its 1140 bp projected revenue growth acceleration from 31.3% this year to 42.7% in 2024.

Shift4 says it is currently “in the midst of a very successful consolidation” of SkyTab POS, with some of the success owing to a significant total cost of ownership (TCO) advantage relative to competitors. Shift4 installed 8,254 SkyTab systems in Q3, or more than 35% of its cumulative install volume since its launch. Bringing existing customers over to SkyTab boosts ARPU as it is resulting in higher subscription fees per merchant.

Finaro and Appetize’s acquisitions are expected to be accretive to revenue and EBITDA growth starting this quarter and expanding in 2024. Combined, the two are expected to contribute nearly $25M in gross revenue less network fees and $6M in EBITDA in Q4. With Finaro in particular, Shift4 is expecting “a very strong Q4 ahead” as “numerous enterprise accounts have begun processing.”

Financially, Shift4 is the strongest of the four, hitting records across a majority of its metrics, from end-to-end payment volumes, revenue, gross profit, and margins. Gross profit rose 34% YoY to $171M and reached a record 26.7% margin, leading to more operating leverage down the line as operating margin expanded to a record 7.9%, up 490 bp YoY. Net margin improved for a second straight quarter to 4.8%, though it remained 310 bp lower relative to a peak at 7.9% in Q3 last year. Adjusted free cash flow grew 69% YoY to $75.5M.

Shift4 Payments Inc. Profit Margins

Source: I/O FUND

In 2024, revenue growth is forecast to be >40% YoY in each quarter, from ARPU expansion from SkyTab, net new merchant additions, and contributions from M&A synergies. This represents a rapid acceleration after a four-quarter deceleration, with quarterly revenue growth rates back to levels seen in 2022. However, the main risk to this case is that a pretty swift deceleration is projected in 2025, with revenue growth dropping back to the 28% range. A more uncertain macro backdrop may create some headwinds in 2024 and lead to early signs of a deceleration sooner than expected in late 2024 or 2025.

AvePoint

AvePoint provides cloud migration, management, and data protection solutions primarily for Microsoft 365, with a suite of products and AI/ML offerings for both cloud and hybrid/on-prem workloads. CEO TJ Jiang is aiming for the company to become a “key enabler of generative AI adoption within enterprises in the coming years,” as he believes AI “will drive a wave of enterprise transformation across all industries.”

Generative AI “obviously is playing a part into the future quarters,” according to Jiang. The launch of Microsoft’s Copilot AI assistant for enterprise 365 users serves as a major tailwind for 2024. This boost, alongside a continued shift to the cloud in Microsoft Office’s commercial customer base, is underpinning an expected 70 bp acceleration in revenue growth to 16.4% in 2024 before a stronger 330 bp acceleration in 2025 to 19.7% growth.

Customer expansion can also help this acceleration pan out, especially if advanced talks with large customers can translate to expanded deal sizes in Q4 and early 2024: AvePoint is in talks with a long-time customer to accelerate their cloud migration, another customer is in “advanced talks” to purchase AvePoint’s Opus solution, and a UK customer is considering expanding the scope of their deployment of AvePoint’s Secure Backup Service Solution.

AVPT Margins Charts

Source: I/O FUND

AvePoint’s financials are improving, though it is not yet GAAP profitable, reporting a GAAP operating loss of ($0.3 million) in Q3, or a margin of (-0.4%). GAAP net margin was (-5.8%), a solid improvement from the (-12%) to (-24%) range reported over the last six quarters. EBITDA margin was 1.2%, the first positive quarter; moving forward, AvePoint needs to keep improving these metrics and post consecutive quarters with positive EBITDA and move closer to GAAP profitability on the bottom line.

AvePoint ARR, YoY Growth

Source: I/O FUND

However, there is one red flag, and that’s in AvePoint’s ARR. ARR growth has been decelerating, from the high 30% range in 2021, to 23% in Q3, and now to a guided 22% YoY in Q4 to $262M. The bull case will be looking for this to bottom in Q4, and the company’s history of raising guidance each quarter this year suggests Q4’s ARR growth could come in slightly above the guide at 23%. In addition, Q4’s net new ARR guide is pointing to a sequential decline to ~$11.4M, but management clarified that this stems partially from macro headwinds but also from a spike in government strength and subsequent revenue pull-forward in Q3.

Avepoint Net New ARR

Source: I/O FUND

This guided sequential decline in net new ARR raises another hurdle for the bull case – a resumption of sequential growth in net new ARR in Q1 and Q2 next year will support this view for revenue acceleration. A further deceleration in net new ARR or ARR will raise the risk that revenue growth fails to accelerate YoY.

AvidXchange

Accounts payable automation and payment solution provider AvidXchange rounds out the list with a minimal 30 bp revenue growth acceleration from 18.6% in 2023 to 18.9% growth in 2024. AvidXchange has posted nine consecutive quarters exceeding its guided outlooks, and this momentum adds a layer of confidence to the acceleration story since a few key metrics continue to decelerate.

Healthy top of funnel growth and a partnership with AppFolio coming online in Q1 next year are two growth levers driving revenue growth higher. AppFolio’s partnership could help drive a reacceleration in transaction volume and payment volume, as AvidXchange will be the first AP application solution in AppFolio with access to more than 19,000 customers.

Fundamentals are improving, but similar to AvePoint, AvidXchange is not yet GAAP profitable. GAAP gross margin is steadily expanding, and is now nearing the 70% level after crossing the 60% threshold in Q1 2022. GAAP operating and net margins improved significantly, by more than 1200 bp sequentially. However, AvidXchange does not yet have the operating efficiency nor leverage to take last quarter’s GAAP net margin of (-8.7%) to GAAP profitability within a few quarters.

AvidXchange Quarterly Revenue Growth, YoY

Source: I/O FUND

Revenue growth is expected to bottom in Q4 and then accelerate in each quarter next year. Q4’s guide is implying a 500 bp sequential slowdown, so the challenge will be quickly bouncing back to >18% revenue growth. However, this acceleration story comes with two main risks – decelerating growth in both TPV and processed transaction volume. Both metrics have decelerated rather sharply, and have not yet shown signs of stabilizing or reaccelerating.

TPV, Processed Transaction Growth

Source: I/O FUND

Conclusion

Cloud has proven to be a very volatile sector over the past few months. Multiple companies have seen 20% or larger moves in either direction following earnings as investors praised hints of accelerating growth or slammed decelerating metrics. Only a handful of cloud stocks are expected to see revenue growth accelerate in 2024 based on current estimates, and only two of the four covered here have substantial near-term tailwinds from AI, but all are seeing steadily improving fundamentals with a handful of intact growth levers for 2024.

Missing expectations is a risk to any of the four, but more so for AvePoint and AvidXchange given that their expected acceleration is minimal. Palantir’s near 200% YTD surge has been warranted because of a shift to GAAP profitability, but its valuation remains expensive and at risk if growth slows slightly. Shift4 arguably holds the strongest fundamental picture of the four, but a higher degree of risk stems from a quick return to decelerating revenue growth in 2025.

I/O Fund Equity Analyst Damien Robbins contributed to this analysis

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

Recommended Reading:

The Strongest Cybersecurity Stocks In Q3

Posted on by io-fund

This article was originally published on Forbes on Forbes Forbes on Nov 30, 2023,09:40pm EST

Cybersecurity stocks have performed well in 2023, rising about +26.5% YTD, with the security backdrop boosted by an increase in data breaches and ransomware. Quarterly spending has increased approximately +12.7% YoY to ~$37.6 billion through the first half of the year, although commentary from sector leaders Fortinet and Palo Alto raised some concerns about spend optimization, with billings forecasts from the two weaker than expected.

Despite beating on the top and bottom lines, Zscaler provided flat billings guidance while revenue growth is set to slow. CrowdStrike was GAAP profitable from operations for the first time ever as net new ARR reached a record, but billings and ARR growth both decelerated.

Cybersecurity Market Growth Slows in Q2

Zscaler and CrowdStrike reported their October quarters this week with both providing important commentary that the macro environment is tougher than usual. CrowdStrike’s management said that buyers still remain cautious since the “macroenvironment remains challenging with continued increased budget scrutiny.” Zscaler said that while the “global macro environment remains challenging, and customers continue to scrutinize large deals, … customer sentiment seems to be stabilizing.”

Looking back at the cybersecurity market through Q2 offers a bit of color on those broader trends impacting growth this year. The market registered a third straight quarterly deceleration in Q2, per Canalys estimates, as the global market recorded +11.6% YoY growth to $19.0 billion.

This marked a slight deceleration from the +12.5% growth in Q1 to $18.6 billion, and a sharper deceleration from the +15.8% growth rate seen in 2022, as the cybersecurity market topped $71 billion for the year.

Cybersecurity Market Growth, Quarterly YoY

Source: CANALYS

Growth in North America remained resilient at +12.6% YoY in Q2, the bellwether of the market considering it accounts for more than half of total spending. Latin America and EMEA growth remained in the double digits, though both decreased approximately 180 to 210 bp sequentially. APAC growth saw the largest slowdown, from +10.7% YoY in Q1 to +8.8% YoY in Q2.

Headwinds Remain in Play in Q3

Budget cuts, consolidation, and optimization are some of the trends at play in the cybersecurity market that are pulling 2023’s growth rates lower. Microsoft CEO Satya Nadella said in January during its fiscal Q2 earnings call that customers were “consolidating on our security stack, in order to reduce risk, complexity and cost.”

CrowdStrike CEO George Kurtz echoed Nadella’s view in the company’s Q1 earnings call in March that customers “want to reduce cost and headcount, reduce the number of point products and agents, reduce complexity and simplify operations.”

Venture capital funding deals and deal value also reflect this challenging environment persisting through Q3. According to Crunchbase, deal count declined just over (-15%) from Q2 to 153. Although deal value was marginally higher at $1.9 billion compared to ~$1.8 billion in Q2, it was about (-30%) lower YoY as large late-stage deals faded. VC funding has totaled just $6.4 billion YTD, on track to mark the lowest level of funding for cybersecurity startups since 2019, which totaled $8.8 billion.

Cybersecurity VC Funding

Source: CRUNCHBASE

Despite such cost and complexity concerns, companies are still committed to protecting data and operations. It’s this point that will drive long-term growth of the industry in the face of these near-term headwinds: there will always be more data to protect.

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Fortinet: Q4 Guidance Soft, Billings to Decline YoY

Fortinet declined (-12.4%) following its Q3 earnings report for three key reasons: Q3 revenues marginally missed estimates, Q4 revenue guide was below consensus, and most importantly, Fortinet is projecting a YoY decline in net billings.

Fortinet reported revenues of $1.33 billion in Q3, which missed expectations by just $20 million. For Q4, Fortinet guided revenues $80 million lower at midpoint than the consensus estimate of $1.49 billion.

Q4 billings were projected to be between $1.56 to $1.70 billion, representing a YoY decline of ~(1%) to (9%). Management’s transition to SASE and security operations, and challenging network comps, are some of the factors behind the revenue slowdown with Fortinet seeing “modest” revenue growth for the next few quarters.

Fortinet Billings Growth YoY

Source: I/O FUND

Fortinet’s billings slowdown and the lowered revenue forecast is a concern as 2023 would mark Fortinet’s slowest billings growth since its IPO in 2009. Growth is estimated at just +10.2% YoY at the $6.165 billion midpoint. It’s also a significant slowdown from the +34% and +35% billings growth seen in 2022 and 2021. Management said the growth slowdown in Q3 stemmed from “1 month shorter contract duration and importantly, lackluster appliance demand.”

A slowdown in product revenue growth is likely a driving factor behind the lowered revenue forecast for 2023. Product revenue is forecast to increase only +9% YoY to $1.935 billion – this is well below 2022’s +42% growth, 2021’s +37% growth, and its +23.7% average growth rate since 2009. CEO Ken Xie said that “the Secure Networking market is experiencing slower growth as product demand returns to normal levels following two years of elevated growth.” He added that “building and product revenue fell below our expectation” due to that slowdown in Secure Networking.

Palo Alto: Billings Weaker than Expected, Underlying Metrics Strong

Palo Alto shares fell (-5.4%) following its fiscal Q1 earnings report, but have since gained more than +14% to rise to new highs. The initial negative reaction stemmed from a lowered billings forecast as well as hints that revenue growth is slowing below 20%, but other underlying metrics remained strong.

Palo Alto reported +20% YoY revenue growth to $1.88 billion and +16% YoY billings growth to $2.02 billion, which came in below its prior outlook for $2.05 to $2.08 billion in the October quarter. This miss is amplifying concerns that revenue and billings growth is decelerating — revenue growth was at the lowest level since fiscal Q4 2020, while billings growth was at the lowest level in more than four years and marks a second quarter with growth below +20%.

Palo Alto Revenue, Billings YoY Growth

Source: I/O FUND

For the full year, Palo Alto lowered its billing forecast to $10.7 to $10.8 billion, from a prior view of $10.9 to $11.0 billion. This correlates to YoY growth of +16% to +17%, roughly in line with the recent quarter’s +16% growth rate. Palo Alto cited volatility in contract duration, increased financing demand, and increased demand for deferred billings plans for the lowered forecast. CFO Dipak Golechha said that the company “saw the rising cost of money have an important and incremental impact on customer behavior in [fiscal] Q1.” Similar to Fortinet, Palo Alto saw minimal growth in product revenue, at just +3% YoY, with the majority of revenue growth driven by service revenue, +25% YoY.

Aside from that, Palo Alto had multiple underlying strengths in the report, especially with its next-gen offerings. Next-Gen Security ARR increased +53% YoY to $3.23 billion, and SASE ARR increased +60% YoY. Palo Alto saw very strong growth in multi-module customers, with +155% YoY growth in those adopting 5+ modules, and +59% YoY growth in those adopting 3+. XSIAM’s pipeline exceeded $1 billion, with more than $500 million of that pipeline added in Q1.

Zscaler: Billings Guide Unchanged, Revenue Growth May Slow

Zscaler maintained its billing guide for the full year, although revenue and EPS both came in ahead of expectations in its fiscal Q1. Large customer growth continued to slow, while fiscal Q2’s guide hinted at a possible deceleration in revenue growth.

Zscaler reported $497 million in revenue, +40% YoY, which handily beat expectations and the company’s guidance for +33% YoY growth to $473 million in revenue. While it did post +131% YoY growth in adjusted EPS to $0.67 and a surge in free cash flow, Zscaler remains unprofitable on a GAAP basis.

GAAP operating loss improved 33% YoY to ($46 million), while GAAP operating margin improved 10 percentage points to (9%). At its scale of more than $2 billion in annual revenue, it’s likely the market will want Zscaler to soon shift to operating profitability, which could be tough at the moment given that sales, marketing and R&D accounted for ~98.8% of gross profit in Q1. SBC also remained high at $129.1 million, or ~26% of revenue.

Billings growth remained strong, at +34% YoY to $456.6 million. However, Zscaler did not raise its full-year billings outlook as it tends to do, even if only by a few million; its outlook remained unchanged at +24% to +26% YoY growth, or $2.52 to $2.56 billion. That outlook suggests that billings growth will decelerate through the remainder of the fiscal year.

Fiscal Q2’s revenue guide also hinted at some early signs of revenue deceleration, with the $506 million guide pointing to YoY growth of approximately +30.5%. Fiscal 2024’s guide calls for +29.5% YoY growth at midpoint to $2.095 billion, again indicating that revenue growth in fiscal Q3 and Q4 is likely to slow to the mid to high-20% range.

ARR Chart

Source: I/O FUND

Growth in large customers of over $1M in ARR has slowed significantly by 21 points over the past year, from 55% growth down to 34%. Growth in $100K+ ARR customers has also slowed from 37% to 22%.

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CrowdStrike: Net New ARR Rises to Record, But Billings Decelerate

CrowdStrike beat on the top and bottom lines and guided fiscal Q4 marginally above consensus. The report in itself was fairly strong, as net new ARR rose to a record and CrowdStrike recorded its first-ever quarter with positive operating income. However, ARR growth and billings growth both decelerated, similar to peers who are also seeing decelerating billings. Management added that “buyers are still cautious” as the “macroenvironment remains challenging with continued increased budget scrutiny.”

Crowdstrike Net New ARR

Source: I/O FUND

Net new ARR rebounded to a record $223.1 million, +12.6% YoY, a strong recovery from Q1 and setting the stage for another possible record to close out FY24. With this rebound in net new ARR, CrowdStrike’s ARR topped $3 billion for the first time, reaching $3.15 billion in fiscal Q3. CrowdStrike emphasized that it is the “fastest and only pure play cybersecurity software vendor in history” to surpass the $3 billion ARR milestone.

However, ARR growth is still decelerating, as is billings growth. ARR growth in fiscal Q3 was +34.6% YoY, a slight deceleration from Q2’s +36.9% YoY growth rate and a sharper deceleration from the +55% YoY growth rate from fiscal Q3 last year. What’s important is that CrowdStrike soon shows ARR bottoming and stabilizing, instead of decelerating further into the +20% range or even the high teens.

Crowdstrike ARR, YoY Growth

Source: I/O FUND

Billings also decelerated, matching what we’ve seen so far with CrowdStrike’s peers. Billings were calculated to have fallen (-2%) QoQ and +9% YoY to $821.5M for Q3, a significant slowdown from the +13% QoQ and +22% YoY growth rate recorded in the prior quarter. You can read more about billings and ARR in our CrowdStrike’s Q3 earnings recaphere.

Crowdstrike billings growth/decline

Source: I/O FUND

Pictured Above: I/O Fund calculations for CrowdStrike’s billings growth/decline

CrowdStrike also recorded its first quarter to generate operating income, albeit at a razor-thin 0.4% operating margin. However, this shift to a positive margin benefited the bottom-line, allowing net margin to expand ~225 bp QoQ to ~3.4%. This marked CrowdStrike’s third straight quarter of GAAP profitability, with sequential growth in each of the three quarters. We had previously mentioned that while CrowdStrike had begun to post GAAP profitability, it was preferable that the company be GAAP profitable from operations rather than interest income – now, the next task is for CrowdStrike to show further growth in operating income.

Conclusion

Aside from Fortinet, the remaining cybersecurity stocks covered here have all rallied to new highs following earnings, despite each report having some weaknesses. Cybersecurity stocks are investor favorites due to an ever-growing need for cybersecurity solutions among enterprises and high cash flow generation metrics – all of the four reported free cash flow margins higher than 30%. Billings growth remains an important metric to track, given the decelerations seen this quarter and hints at more deceleration ahead. Yet, these key metrics are providing clues as to which companies will be strongest moving into 2024.

Damien Robbins, Equity Analyst at the I/O Fund, contributed to this article.

Recommended Reading:

CrowdStrike Q3 Earnings: Net New ARR Accelerates, Billings Decelerate

Posted on by io-fund

The word “record” was emphasized in the opening remarks as CrowdStrike put up a record quarter in many regards: record net new ARR of $223 million, record non-GAAP subscription gross margin, record GAAP and non-GAAP operating profitability, and record free cash flow.

What is weighing on CrowdStrike after hours is the deceleration in billings. CrowdStrike prefers to focus on ARR and Net New ARR, yet the market is keeping an eye on billings, especially this earnings season, considering we’ve seen mixed results on billings from cybersecurity peers. We detail this for you below.

The other blemish, if you will, was when the CFO stated: “our dollar based net retention rate was slightly below our benchmark in Q3.” This means DBNRR was below 120. Looking back, the July 2022 quarter was at 120%. However, I believe this is the first time that DBNRR was below 120.

Beyond this, the company had a solid report. It was the first quarter the company was profitable from operations (as you’ll recall, CrowdStrike was profitable from interest income in the past). Net new ARR also accelerated nicely from (-10%) last quarter to +13% this quarter. This helps to set the stage for more growth in the future.

Key Takeaways:

CrowdStrike delivered a 1.1% revenue beat and 10.8% EPS beat relative to consensus estimates, and guided fiscal Q4 marginally above consensus; however, the quarter was relatively strong, as net new ARR rose to a record at $223 million. ARR growth decelerated slightly to 35%, but topped the $3 billion mark for the first time. CrowdStrike re-emphasized its goal to reach $10 billion in ARR over the next five to seven years. The company also stated “we are maintaining our net new ARR assumptions which call for in-line to modestly up net new ARR for the full year and double-digit year-over- year net new ARR growth in the second half.” This implies net new ARR will be strong again next quarter.

Revenue growth remained strong at +35%, but billings growth looked to decelerate to the high-single-digit range YoY, compared to prior growth rates above +20%. A key item in the report was that Q3 marked CrowdStrike’s first quarter with positive operating income. CrowdStrike now has to prove that it can continue to expand operating margin further into positive territory.

Financials:

Revenue and EPS:

  • Revenue of $786 million beat consensus estimates by $8.6M. This represented growth of +35% YoY
  • Subscription revenue was $733.5 million, up +34% YoY.
  • ARR increased +35% YoY to $3.15 billion, marking the first time that ARR has surpassed $3 billion.
  • Net new ARR reached a record at $223.1 million, and was +12.6% higher compared to $198.1 million in the year-ago quarter.
  • Adjusted EPS of $0.82 beat estimates by $0.08, or 10.8%. This represented YoY growth of +105%.
  • GAAP EPS of $0.11 compares to a GAAP loss of ($0.24) in the year-ago quarter.

Margins:

  • Gross margin of 75.2% increased ~240 bp YoY ~20 bp QoQ.
  • Subscription gross margin of 78.2% increased ~270 bp YoY and ~40 bp QoQ.
  • Operating margin of 0.4%, compared to an operating margin of (9.7%) in the year-ago quarter and (2.1%) in fiscal Q2.
  • Net margin of 3.4% expanded ~225 bp QoQ, and marked the third straight quarter with a positive net margin.

Cash & Debt:

  • Cash and short-term investments of $3.17 billion.
  • Total debt was $742.1 million.
  • Operating cash flow reached a record at $273.5 million, representing an increase of +12.6% YoY from $242.9 million. Operating cash flow margin was 34.8%.
  • Free cash flow reached a record at $239 million, an increase of +37.3% YoY from $174.1 million. Free cash flow margin was 30.4%.

Noteworthy:

Net new ARR growth and a first quarter with positive operating income were the two major positives from Q3’s report. Net new ARR rebounded to a record $223.1 million after falling to $174.2 million in fiscal Q1, a strong recovery and setting the stage for another possible record to close out FY24.

CrowdStrike also recorded its first quarter to generate operating income, albeit at a razor-thin 0.4% operating margin. However, this shift to a positive margin benefited the bottom-line, allowing net margin to expand ~225 bp QoQ to ~3.4%. This marked CrowdStrike’s third straight quarter of GAAP profitability, with sequential growth in each of the three quarters.

We had mentioned in the pre-ER write-up that while CrowdStrike had begun to post GAAP profitability, it was preferable that the company be GAAP profitable from operations – now, the next task is for CrowdStrike to show further growth in operating income. You can read our last earnings report write-up following Q2 earnings here.

Another interesting snippet was an increase in the number of customers deploying 7+ modules. Whereas customers deploying 5+ remained the same QoQ at 63%, the amount deploying 7+ increased from 24% last quarter to 26% this quarter. Those deploying 6+ modules also increased by 1 percentage point to 42%. CrowdStrike has done an excellent job of upselling existing customers to higher amounts of deployed modules, so this 2 percentage point increase was a healthy figure to see.

Billings:

However, there was one glaring negative from the report – billings growth has decelerated to the single digit range. Billings was calculated to have fallen (2%) QoQ and +9% YoY to $821.5M for Q3, a significant slowdown from the +13% QoQ and +22% YoY growth rate recorded in the prior quarter.

Pictured Above: I/O Fund calculations for CrowdStrike’s Billings growth/decline

This deceleration matches what peers are reporting:

  • Fortinet guided for billings to decline (-1%) to (-9%) in its upcoming quarter after reporting just +5.7% YoY growth.
  • Palo Alto lowered its full-year billings forecast while it reported a slowdown to +16% growth compared to +27% in its year-ago quarter.
  • Zscaler reported +34% YoY billings growth on Monday, but maintained its full year guidance calling for +24% to +26% YoY growth, suggesting that a deceleration is set for the next few quarters.

Earnings Call:

Billings:

Given Billings is where the potential weakness resides, there was a question from an analyst regarding the decline. Since this was the most important question on the call in regards to the price action, I’m quoting it below.

Q: “And then quarter was phenomenal. But I do see some weakness across the board of cyber companies with billings. In your case it was down about 2%. I also see some weakness in deferred revenues. How do I reconcile what I see with billings with deferred, with the underlying drivers that are very strong and your strong execution? Why is why are we seeing weakness not just with you, maybe with the entire space, but why are we seeing weakness with billings across the board? Thanks.”

A: CFO: I'm going to start with billings. Yeah. You're correct. For us specifically, we don't manage the business to billings. And we feel ARR gives you the absolute best proxy to revenue. And we felt that that's the right metric. As you know, since we went public to give you more transparency into the health of our business. And that's the metric that really guides you on health.

[…] We think that billings has certain things that just are not as relevant as a metric like ARR, you're comparing a balance sheet item to a P&L item and for us, the P&L is going to dictate the health of the business. So for us billings obviously is going to be impacted by duration and there are many things that go into that. And remember also that when you think about on a year-on-year basis, we're still up on billings. And I think that's the one thing that you want to take away. For us, when we think about how we want to continue to be transparent, ARR really gives you that notion of where we're going and how we're doing. And I think that that's the focus and it has been, by the way, since we've been public. Even as a private company, that's the one that we manage the business to, that's how we look at how to give out quotas to our reps, et cetera, et cetera. So for us that's not going to change. And, I hope that answers that question.”

Translation: CrowdStrike’s CFO did not really answer the question, such as perhaps seasonality contributed or some deferred revenue will be realized in Q4 that would have been realized in Q3 (these are hypothetical answers). Instead, the CFO answered that analysts should focus on ARR instead of Billings, but the problem is that ARR is not a GAAP metric and this is why Billings remains important for an apples-to-apples comparison with peers. This is something to monitor, yet given net new ARR accelerated, the market may conclude these two cancel each other out. 

Macro Environment Weak:

The other takeaway was CrowdStrike’s discussions that the current environment is tough. CrowdStrike may be less susceptible, yet management made it quite clear they are facing challenges. Here is what the CEO said when asked if October was strong (given other cybersecurity peers have stated it was a weak month for them):

“Yeah, we certainly had a strong October. I think as I said in my prepared remarks, the macroenvironment is still is still challenging. And we make no mistake about that. Deals take longer, a lot more scrutiny a lot of sign-offs, and there's a lot more work that goes into these larger enterprise deals. Getting deals done, even like Falcon Flex, which are more enterprise-like in their nature, takes time. So, we had a great October, but in general, buyers are still cautious. And I think the fact that we're able to provide a real platform play that allows them to consolidate in other technologies and ultimately save money accrues values to us, but it certainly takes a lot of time and effort to get the deal over the goal line, but team did a great job, and October was strong for us.”

Management also stated they are not counting on a Q4 budget flush in their guide, which translates to a weaker environment: “As George outlined, strong demand for the Falcon platform is driving our pipeline to new heights. However, the macroenvironment remains challenging with continued increased budget scrutiny, and as a result, we are not expecting to see the typical Q4 budget flush.”

You can read our previous write-up on CrowdStrike’s product including AI-driven automation.

Conclusion:

As redundant as it may sound, we will rely on technicals to manage this position. We tend to rely heavily on fundamentals during pullbacks/selloffs or when the risk/reward is favorable for another leg up in the market. However, we use technicals for risk management when the market appears overextended. There were some weak areas in the report that were canceled out by a few metrics that really matter in terms of a strong foundation, such as operating profitability and accelerating/return to growth in net new ARR. We continue to see CrowdStrike as a strong choice within cybersecurity and this earnings report does not change our view.

You can read the current technical setup here in terms of what we want to see in terms of price levels.current technical setup here in terms of what we want to see in terms of price levels.

Equity Analyst Damien Robbins contributed to this analysis

 Recommended Reading:

The Next Market AI Will Disrupt Is Cybersecurity

Posted on by io-fund

This article was originally published on Forbes on Forbes Forbes on Sep 29, 2023,12:05am EDT

Cybersecurity is one of the highest costs that enterprises face at 12% of IT budgets on average, and this cost is rapidly rising. While a company can lay off staff or reduce marketing and R&D expenses during a period of lower growth, enterprises cannot compromise on cybersecurity. The rise in the number of attacks and the increased sophistication of attacks means this expense will continue to grow, yet AI and automation can help.

According to Cybercrime Magazine, if cybercrime were a country, it would be the world’s third-largest economy, second to the United States and China. The costs that enterprises dedicate to cybersecurity are expected to increase from $8 trillion to $10.5 trillion by 2025. Statista agrees with Cybercrime Magazine’s estimates, stating the cost of cybercrime will reach $10.3 trillion by 2025 and $13.8 trillion by 2028.

At the I/O Fund, we are positioning for AI and automation to play an important role in this critical, no-compromise industry. There are 560,000 new pieces of malware detected every day, and software systems cannot keep up with this. AI is already assisting human teams in identifying which threats require more analysis, and in the near-term, this will meaningfully lower cybersecurity costs. There is also a shortage of cybersecurity talent, with a 2022 survey stating 59% of companies have a shortage in this department and may not be able to effectively handle a cybersecurity attack.

Below, we look at how AI is set to disrupt cybersecurity next and what is being said on the topic.

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How AI Can Improve Incident Response and Threat Detection

Combining cybersecurity with AI has a natural affinity as cyberattacks are computer generated, and in turn, computers are uniquely capable of finding computer-generated threats. Automation reduces the number of false positives. Instead of getting every piece of telemetry that requires the security team to investigate, AI-assisted endpoint detection and response solutions eliminates the noise so that the security team is only responding to those that have the potential to be critical.

Fundamentally, cybersecurity is a data problem. Cybersecurity platforms ingest, correlate, and query petabytes of structured and unstructured data from disparate external and internal sources in real-time. Cybersecurity platforms then build rich context and deliver greater visibility by constructing a dynamic representation of data across an organization.As a result, AI-driven cybersecurity platforms are often highly accurate in triggering a response.

The number of endpoints in a corporate network are exponentially growing with 27 billion endpoints expected to be connected by 2025. There have been staggering studies done that show 68% of enterprises have experienced a compromised endpoint. Compromised credentials across desktops, laptops, and mobile devices are often the hardest points of access to secure. Algorithms can detect new malware on endpoints based on the attributes of known malware. Unauthorized access, data breaches and cyber threats from endpoints will also help to drive demand for edge-based, decentralized AI cybersecurity solutions.

The network security market is a large contributor to cybersecurity spend. Machine learning algorithms help systems to learn by experience, which helps to identify malware in encrypted traffic and find insider threats. Machine learning algorithms do not need to decrypt, rather can spot the malicious patterns and find threats hidden with encryption.

Cloud security is the fastest growing segment within cybersecurity. AI/ML can help to identify suspicious cloud app logins, detect location-based anomalies, and quickly identify threats through IP reputation analysis. Threat prevention is possible through ingesting cloud telemetry with AI systems, foregoing the need for expert rule engineering. Attack path simulation is also made possible with AI, to help simulate the path an attacker would take to reduce coverage gaps. Egress web traffic can be monitored without the need to configure virtual machines by focusing on limiting egress based on source, identity, destination and request types. Machine learning models can also detect new API threats based on large training data sets. These are a few examples of how AI/ML is improving cloud security.

Chat-GPT heightens security risks as generative AI is capable of writing malicious code or acting as a sidekick to the human hacker writing malicious code. To level the playing field, the best defense will also be self-learning, generative AI tools. The downloads for Chat-GPT have plateaued considerably among consumers. Meanwhile, the use of Chat-GPT among hackers is rising on an exponential curve. This helps illustrate why the adoption curve for AI may be healthier among enterprises (rather than consumers) in the medium-term.

According to Mackenzie Jackson, a developer advocate with GitGuardian, Chat-GPT is likely to give rise to a greater number of hackers. This new generation is called “AI Hackers” because previously they could not hack on their own, but are now able to hack with generative AI as their sidekick.

Generative AI used for nefarious purposes

Source: RAPID7: BAIN & COMPANY

Every Thursday at 4:30 pm Eastern, the I/O Fund team holds a webinar for premium members to discuss how to navigate the broad market, as well as various stock entries and exits. We offer trade alerts plus an automated hedging signal. The I/O Fund team is one of the only audited portfolios available to individual investors. Learn more here.Learn more hereLearn more here.

What the C-Suite is Saying About AI & Cybersecurity

McKinsey released a recent report where 53 percent of organizations believe generative-AI is driving new risks in cybersecurity. Not only can AI help enterprises expedite threat detection, but hackers can also expedite the end-to-end attack life cycle. In another survey, 38 percent of enterprises stated they are mitigating AI-related cybersecurity risks compared to 32 percent who are mitigating inaccuracies, indicating cybersecurity is the top risk that is AI-related at this time.

According to Forbes, 56% of enterprises ranked governance, security and auditability issues as their highest-priority concern with AI/ML spend. This survey was completed in 2021, and it’s likely this number is higher today.

What Public Company CEOs are Saying

Microsoft has one of the largest cybersecurity businesses in the world at $20 billion. This is larger than six best-of-breed companies combined. The company has been working for years on new automation features called CoPilot, which was released to the public this month. Although it’s being marketed for Windows, Office 365 and the browsers Bing and Edge, yet will also become an AI companion for it’s cybersecurity business. Per the CEO in the most recent earnings call: “our Security Copilot, the first product to apply this next generation of AI to SecOps will be available to customers via paid early access program this fall.”

Beth Kindig Twitter Post

Source: BETH KINDIG'S TWITTER

Palo Alto Networks is a company that has outsized returns this year of up to 78% following the most recent earnings call. It’s currently trading at 66% gains YTD. The CEO stated in the most recent earnings call: “I think what's important to understand is that over the last five years, cybersecurity TAM has continued to rise. It has grown at approximately 14%, and it has grown twice the pace at which the IT market has grown […] and possibly now with the sort of arrival of AI as a mainstream opportunity, every one of us is trying to make sure we grab that with both hands. So, we will continue to see the pace of technology spend go sort of up or forward.”

Palo Alto Price Change

Source: YCHARTS

Cloudflare is a stock that is up 35% YTD and is edging out the Nasdaq-100 this year, which is no small feat given the rally Big Tech has seen. The CEO recently stated that his company is seeing an uptick in business on their R2 product: “And by our estimates, Cloudflare is the most commonly used cloud provider across the leading AI startups. They're using R2 to help arbitrage the lowest GPU cost to train their models.”

Conclusion:

Using AI to identify threats and for pattern recognition and anomaly detection is not new by any means. Rather what is rapidly coming to market are platforms enabled with generative AI and automation that is self-learning, so that a threat is detected before it occurs rather than after the cyberattack. Rather than threat detection, the ultimate goal is threat prevention.

AI will not entirely replace security professionals anytime soon, but it can contribute to efficiency by automating threat detection, analyzing data sets, and by continuously learning to identify anomalies and new attacks before they occur. By offering agentless solutions, theoretically, fewer human agents will be needed. For new technologies, the adoption curve can be challenging (go ask virtual reality enthusiasts how that’s going). But for industries where AI can offer a value proposition that can predictably lower costs at a reasonable price, a market will form. We think one of the next markets to be disrupted by AI will be cybersecurity.

If you own cybersecurity stocks, or are looking to own cybersecurity stocks, we encourage you to attend our weekly premium webinars, held every Thursday at 5:00 pm EST. Next week, we will discuss a cybersecurity stock we recently entered and one that we are eyeing closely – what our targets are, where we plan to buy, as well as where we plan to take gains.

I/O Fund Equity analyst, Royston Roche, contributed to this analysis.

Recommended Reading:

Cybersecurity Stocks Overview

Posted on by io-fund

Cybersecurity was a wild ride this earnings season with stocks such as Fortinet down (25%) after its report, yet stocks like Palo Alto Networks up 15% following its report. This is important to dissect as Palo Alto is the leader YTD in gains while Fortinet is the laggard (see chart below).

Source: YCharts

We think the market is more forward-looking than ever when it comes to the cybersecurity space as the key metrics is what separates these names. Below, we look into the key metrics to help predict where the market will go next.

Revenue and EPS

Before we go into key metrics, let's first review top line and bottom-line numbers. Here is how the leading cybersecurity stocks stack up on revenue. Zscaler and CrowdStrike are leading in revenue growth in the recent quarter with YoY growth of 43.1% and 36.7%, respectively.

Zscaler’s revenue grew by 43.1% YoY to $455 million and CrowdStrike’s revenue grew by 36.7% YoY to $731.6 million in the recent quarter.

Forward looking, CrowdStrike leads highest revenue growth rates in the next two quarters and yet Cloudflare edges out CrowdStrike in the early part of next year – per analyst consensus.

  • CrowdStrike’s revenue is expected to grow 33.8% YoY in Q3 2023 and 31.3% YoY in Q4 2023.
  • Cloudflare’s revenue is expected to grow 29.6% YoY in Q1 2024 and 30.2% YoY in Q2 2024.

Source: Seeking Alpha

CrowdStrike’s adjusted EPS is expected to grow the fastest in the next three quarters with 85.6%, 66.3%, and 36.6% YoY growth. Zscaler beats CrowdStrike in Q2 2024 with 21.1% YoY growth while CrowdStrike’s EPS is expected to grow 15.1% YoY in that particular quarter.

Source: Seeking Alpha

Margins

We'd also like to discuss margins as a group before we break the stocks down individually. For brevity’s sake, we are placing the most importance on GAAP operating margin. This highlights why Palo Alto Network has led cybersecurity stocks this year, as the company’s growth profile is balanced with operational efficiency.  

Source: YCharts and Company IR

Palo Alto’s operating margin improved to 13% from 1% in the same period last year. CrowdStrike and Zscaler are also improving as can be seen in the below chart.

  • CrowdStrike improved to (2%) from (9%) in the same period last year.
  • Zscaler improved to (10%) from (26%) in the same period last year.

Source: YCharts

Key Metrics

Below, we look at key metrics among cybersecurity stocks to help determine which companies may be stronger than they seem, or the opposite, weaker than they first appear.

CrowdStrike

For CrowdStrike ending ARR and net new ARR are two important key metrics. Per CrowdStrike’s management: “And as you know, the business is focused on ARR, as opposed to billings, which can be — which can have whipsaw effects and the focus on ARR, just gives you an idea about the overall health of the business.”

Ending ARR grew by 37% YoY in the recent quarter to $2.93 billion. This was partly helped by the rapid growth in cloud security, identity protection, and LogScale Next-gen SIEM, which together surpassed $550 million in ARR with very high growth rates:

  • LogScale SIEM ending ARR grew by over 200% YoY in the recent quarter and is approaching $100 million and the management expects to achieve in Q3.
  • Falcon modules deployed in public cloud grew by 70% YoY to $296 million.
  • Identity Protection ending ARR grew by 194% YoY to over $200 million.

Source: Company IR

Net new ARR declined by (10%) YoY to $196.2 million yet was better than management’s guidance of a decline of (11%). In the earnings call, management pointed toward net new ARR returning to growth in the second half of the year: “With the business momentum we see and competitive market dynamics, we believe our second half performance will yield double-digit net new ARR growth.”

Source: Company IR

Palo Alto

For Palo Alto, billings and RPO are the two key indicators. Palo Alto’s billings grew by 18% YoY to $3.2 billion. Despite billings growth showing a deceleration, it’s actually quite strong due to the tough comps as billings grew by 44% YoY in the same period last year.

The management guided billings to grow in the range of 17% to 19% for the next quarter. They also expect billings to grow in the range of 17% to 19% for the next three years. Dipak Golechha, CFO of the company said in the earnings call, “We have the product portfolio that makes us an attractive partner to these players, along with the scale to make the investments to support the success of these partners. Bringing this together on the top line, as Nikesh noted, we're targeting growth of 17% to 19% in revenue and billings over the next three years, which is ahead of the cybersecurity market growth rates.”we're targeting growth of 17% to 19% in revenue and billings over the next three years, which is ahead of the cybersecurity market growth rates.”

Source: Company IR

Remaining Performance Obligation (RPO) grew by 30% YoY in the recent quarter to $10.6 billion. The management believes RPO is a better metric than billings since it is not impacted by billing terms that impacted billings due to customers preferring deferred payments in the current environment. Per the earnings call: “The percent of bookings that included deferred payments increased approximately 45% year-over-year […] and also: “RPO is becoming a more important leading indicator for our business as it's not impacted by billing terms [..] As a reminder, RPO represents the booked business we expect to recognize as revenue in future periods. Also, all customers' purchases, including in RPO, are noncancelable.”

Source: Investor Presentation

Fortinet

Billings grew by 18% YoY to $1.54 billion in the recent quarter, which was a disappointment to the market. Ken Xie, CEO and Founder of the company, said in the earnings call, “Billings growth of 18%, led to more normalized product revenue growth of 18%. We believe our billing performance reflects large enterprises’ concerns with the macro environment, in addition to some inventory digestion after two years of elevated 30%+ of product billing growth during the supply chain shortage.”product revenue growth of 18%. We believe our billing performance reflects large enterprises’ concerns with the macro environment, in addition to some inventory digestion after two years of elevated 30%+ of product billing growth during the supply chain shortage.”

The management cited macro uncertainty led to shorter contract duration and enterprise deals getting pushed out to future quarters for the slower billing’s growth of 18%. Keith Jensen, CFO of the company, said, “We saw shorter contract duration with the average term decreasing 1.5 months to 28 months, creating a 4 to 5-point billings headwind year over year. Normalizing billings growth for the change in contract duration, yields billings growth in the low 20% range. Having some level of enterprise deals push to future quarters is not unusual. In Q2’23, however, an unusually large volume of deals that we expected to close in June, instead pushed to future periods.”

The above explanation from the management was not convincing as it lowered the company’s revenue guidance to $5.35 billion to $5.45 billion, representing a YoY growth of 22.3% at the mid-point from an earlier estimate of $5.425 billion to $5.485 billion.

  • Revenue for Q3 is expected to be $1.315 billion to $1.375 billion, representing a YoY growth of 17% at the midpoint.
  • Billings in the range of $1.56 billion to $1.62 billion, representing a YoY growth of 12.8% at the mid-point.

Source: Company IR

Cloudflare

The company’s paying customers grew by 15% YoY yet large customers (> $100,000 annualized revenue) grew by 34% YoY to 2,352.

Thomas Seifert, CFO of the company said in the earnings call, “Turning to our customer metrics. In the second quarter, we had 174,129 paying customers, representing an increase of 15% year-over-year. We ended the quarter with 2,352 large customers, representing an increase of 34% year-over-year and an addition of 196 large customers in the quarter. In fact, we added a record number of customers spending more than $500,000 on an annualized basis with Cloudflare. And the second quarter was also one of our highest quarterly additions of customers, spending more than $1 million annually, including our largest Zero Trust contract to date.”

The dollar-based net retention rate was 115% compared to 117% in Q1 23 and 126% in the same period last year. He further said,

“Importantly, renewal rates in the second quarter were consistent with the quarterly average in 2022, which was an all-time high for the company. Instead, similar to the last two quarters, the decline in DNR was again primarily driven by slower expansion in our larger customer cohort. We calculate DNR by comparing the analyzed revenue from paying customers four quarters prior to the annualized revenue from the same set of customers in the most recent quarter. As a result, this will be a lagging indicator of Cloudflare’s underlying business trends. Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”Based on our visibility, we believe the deceleration in DNR is nearing a bottom.”

Source: Company IR

Zscaler

  • Customers with over $100,000 in ARR grew by 25% YoY to 2,609.
  • Calculated billings grew by 38% YoY and up 49% QoQ to $719 million. The total billings benefitted from $20 million upfront billing on a multiyear deal. The calculated billings grew 40% YoY in Q1 and 57% YoY in the same period last year. 

Source: Company IR

Conclusion

We are currently looking to add cybersecurity exposure to our portfolio, ideally on a pullback, to position into 2024. There are many strong candidates highlighted here that are performing better than other cloud cohorts. In particular, there are many mentions throughout of the key metrics listed above bottoming. Should these key metrics bottom on any particular stock, the market will likely reward that stock. Our plan is to front-run this bottom with a small allocation and then layer-once the bottom has been confirmed.

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Microsoft FYQ4: Cooling Off Before AI Heats Up

Posted on by io-fund

Let’s be real, the Nasdaq has rallied more than it has in its 52-year history off fairly unimpressive top line growth in the tech industry and minimal to no earnings growth.

Although fellow growth investors have greatly benefited, we shouldn’t be surprised if the buying is exhausted at the moment. The reaction to Microsoft’s earnings is a clue that this could be the case.

Microsoft was in line for this quarter. However, the guide was a tad weak at $52.3 billion compared to $54.5 billion. It’s also important to note that estimates had been coming down going into the ER. We had consensus of $54.9 billion a month ago.

The operating margin of 43.3% is expected to be flat moving forward, which is good news for AI chip investors such as ourselves, because some of the capex is going toward data center buildouts and outsized AI demand. Also, Microsoft has a strong margin right now so flat is certainly acceptable. Part of Microsoft’s strong margins comes from extending the useful life of their servers and equipment, which we’ve covered in the past. 

Psychologically, Azure dipping below Google Cloud revenue growth rate for the first time is not ideal. The reality is that Azure is growing at a similar growth rate on a much higher revenue base, but headlines will take hold of these oversimplified percentages. Within Azure, AI contributed 2% and management stated this is the number to watch moving forward. Regardless, if optimizations end and we see recurring software from AI kick-in, we should see Azure bottom and accelerate in growth in calendar year H1 2024. This is key for MSFT investors. Reference more notes below.

Copilot 365 is among the top reasons to remain invested in Microsoft. For $30/per user per month, enterprises can increase developer productivity by 40% to 50%. It sounded like this will be in general availability by FYH1 with results showing in FYH2 (which is calendar year H1 2024). Having deep pockets to acquire GitHub, and then rolling-out CoPilot 365 is an example of AI being a winner-takes-all market; which is that these acquisitions were carefully placed years ago.

Similar to our note on Google last night, Microsoft’s capex comments spell good things for our particular holdings in the semi-industry. With this level of exposure, these comments are arguably more important for IOF Members than Microsoft’s individual results. The market will go up (and down), but as long as capex increases, we should be in good shape with our current holdings.

There are additional questions from analysts noted below about when optimization will potentially end, when Azure will increase its growth rate, and when AI will start to affect revenue. All of these are important to note, and the pertinent Q&A is highlighted for you below.

Scorecard:

Figures are for FYQ4 ending in June and year-over-year, unless otherwise stated:

Revenue and EPS:

  • Consensus earnings of $2.54 versus $2.70 EPS Reported
  • Midpoint guidance of $55.35B (+7 y/y) and Consensus of $55.42B versus $56.2B Reported
  • FY24 Q1 consensus of $54.53B versus FY24 Q1 Guidance of $54.250B

Microsoft sales guidance by division 

  • Azure & other cloud – +26-27% y/y in constant currency, includes about 1% from AI services versus 26% Reported and 2% from AI Services
  • Productivity & Business Processes – $17.8B to $18.28B, +8.7% midpoint. CC guidance is 10% to 12% versus $18.3B up 10% and 12% on CC Basis
  • Intelligent Cloud – $23.6B to $23.9B up 13.6% midpoint, CC guidance is 15-16% versus $24 billion, up 15% and 17% on CC Basis
  • Personal Computing – $13.35B to 13.75B, (-5.6%) y/y at midpoint versus $13.9 billion (-4%) and (-3%) on CC Basis.

Margins

  • Q4FY23 MSFT gross margin of guidance of 69.5% vs Q323 of 69.5% actual vs Q223 of 67% actual versus 70.1% Reported
  • Q4FY23 MSFT operating margin of guidance of 42.1% vs Q323 of 42.3% actual vs Q223 of 41% actual versus 43.3% reported 

Cash flow + Cash 

  • Q3FY23 operating and free cash flow was $24.5B and $17.8B respectively versus $28.7B and $19.8B
  • Q3FY23 cash stood at $104B and $48B in debt versus $111.3B in cash

Earnings Call:

The number 1 question is this — when will Microsoft begin to realize strong growth from AI? Given AI has been the primary driver in this historic Nasdaq rally, we want to make darn sure there is AI revenue on the way (and soonish). I think some investors are going to get burned by piling AI stocks far too early, for example. But for Microsoft, we are a mere 9-12 months out. I’m including the quote below because this analyst is unfiltered in terms of how exciting the modeling can become:

Karl Keirstead

Okay, great. Amy, if I could double-click a little bit on the exciting news around M365 Copilot as everybody on the line looks to layer that opportunity into our models, I just wanted to get your views. Are there any guardrails you'd offer us to sort of keep us in line? Is there a degree of gross margin pressure in the Office segment? In other words, is it a fairly cost-intensive new product that we should keep in mind? And also, could it pull along Azure in the sense that you need Azure AD and perhaps some of the other cybersecurity products? So a little color there might help everybody with their modeling exercise tonight and in the coming weeks.

Amy Hood

Thanks, Karl. I think maybe I'll first start with the process we have when we release new products. And I absolutely understand we are excited, too, by the demand signal, the customer reaction, really the requests we're getting to be in the paid preview. It's all encouraging. As you know, we've — last week, we announced pricing, then we'll continue to work through the paid preview process get good feedback. Then we'll announce the general availability date, then we'll get to the GA date. Then we'll, of course, be able to sell it and then recognize revenue.

And that is why I continue to say that I am just as excited as everyone else about this, and it should be more H2 weighted. And we've, I think, given you some sizing opportunities. And I think I would use all that. But I do think this is really about pacing. And of course, we've still got to get our Security Copilot and some of the Dynamics workloads priced and released. And we'll continue to work toward that.

My note: this is calendar H2, so within 9-12 months, we should have a decent start on what AI can do for Microsoft on recurring software.

This is a brief comment on when cloud optimizations will end—which should be the perfect storm if we can get cloud to resume growth and then AI layered on top: “I think, in the next couple of quarters, what is the last catch-up optimization.” My note: I imagine this also means 9-12 months out.

Similar to Google, the comments on capex were bullish:

“To support our Microsoft Cloud growth and demand for our AI platform, we will accelerate investment in our cloud infrastructure. We expect capital expenditures to increase sequentially each quarter through the year as we scale to meet demand signals.”

Later, it was also stated: 

“And we do expect, as you asked and Satya talked about, the pace of this adoption curve, we do expect to be faster. So you're seeing the CapEx spend accelerate in Q4 and then again in Q1, and we've talked about what it should look like the rest of the year” and then also: “So it's why I do comment quite often that it's both overall Commercial Cloud demand and building out capacity for AI. It's both.” My note: That’s bullish for AMD, as well, in terms of CPUs.

The CEO also stated this, which I think is interesting for our particular holdings, which is that the rate of investment is higher than the Cloud growth rate right now. “Yes. And I think just for perspective, I think it's sort of always good to think about it, right, where we have, what, 111 [billion] commercial cloud business growing at, what, 22% year-over-year. And then you had a CapEx growth, which is around the same number, 23%, 24%. So in some sense, it's sort of replacement capital plus some new capital that is going to drive new growth.” My note: keep it coming on the capex! ☺

Lastly, Microsoft expressed they believe they are the best data platform on the market. Of course, this is biased but I want to earmark this for as we go along because the argument the CEO is making is important:

“I mean to give you a flavor for it, right, so you have your data in an Azure data lake. You can bring SQL Compute to it. You can bring Spark to it. You can bring Azure AI or Azure OpenAI to it, right? So the fact is you have storage separated from all these compute meters, and they're all interchangeable, right? So you don't have to buy each of these separately. That's the disruptive business model.”

Conclusion:

I chose to cover Google quickly last night because Microsoft (as always) came in as-expected. This is not a dramatic stock to own, rather is a good choice for those who prefer their drama comes elsewhere, and outside of their pocketbook. 

The Nasdaq is due for a breather and I’m kinda hoping for a selloff so we can load up at lower prices in the Fall and Winter. Amy Hood has archery-like skills when she provides guidance – she hits the bullseye on her numbers frequently. Because it’s coming from her, I have it written in ink to expect AI revenue to appear in calendar H1 of 2024. The remaining question of how to best position (and when) will be answered through Knox’s notes and trade alerts on Advanced Market Signals. 

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June Stock Tip: Microsoft Valuation And Buy Plan

Posted on by io-fund

Please reference our fundamental analysis on Microsoft here: “Microsoft: AI Will Help Drive $100 Billion in Revenue.”

Valuation:

In the case of Microsoft, we have used a sum-of-the parts valuation model alongside traditional metrics to determine a price target. The SUTP helps to separate and value the three main businesses – Intelligent Cloud, Productivity and Personal Computing – as each have different growth profiles. 

Factoring in the AI/ML drivers we’ve described, we revisited our sum-of-the parts analysis. These drivers will have the biggest impact on the Productivity and Intelligent Cloud Businesses.

We believe the implied market multiple assigned to the Intelligent Cloud and Productivity businesses still undervalues the potential revenue opportunities.

As Microsoft continues to further integrate AI/ML into its offerings, this will further strengthen its core offerings and be the catalyst for new ones. This will provide new revenue opportunities from its installed Fortune 500 client base which we believe warrants a higher multiple. 

Under our base case scenario, these drivers increase the SUTP by $40 per share and under the bull case by $70 leading to a total SUTP of between $360 and $390 versus the current price of $330. 

Conservatively assuming that Microsoft’s group operating margins remain at current levels, a $100 billion increase in revenue could potentially add an additional in $40B in operating profit.

Based on this scenario, MSFT AI could earn $4.67 (vs MSFT consensus of $9.65 FY 2023). Placing a 30x multiple on gets you about $140 per share. So MSFT + MSFT AI = $485.

To be conservative for now, we can say MSFT AI may generate between $4.00 to $5.00 per share in earnings.

We can also take the avg of the 2 SUTP (390 + 485) for a SUTP value of about $440 over the next few years under the 100B AI scenario.

Buy Plan:

Considering where we are in the business cycle, it’s best to understand Microsoft within the context of the broader market. Our general market outlook is that the market will likely experience a bout of volatility into the summer.

As long as the S&P 500 holds the 4225-4200 region, we can continue to see a continued bullish swing into later 2023/early 2024, before the recession starts to get priced into equities. Until the FED starts a fresh liquidity cycle, and we get eyes on the extent of damage the 2022 rate cycle caused in the economy, we expect choppy price action with a downward bias, with the potential for one more-larger push higher, at most. If this plays out, we could see the NASDAQ-100, and even the S&P 500 make new highs; however, small caps, financials, and many other economically sensitive areas of the market have likely topped.

That being said, there are two general paths we are tracking in MSFT:

Blue – As bullish as price action in Microsoft has been, we only have a 3-wave move off of the January low in Microsoft. This leaves the door open to the uptrend in 2023 being the corrective bounce in a much larger corrective pattern that began in early 2022. The catalyst would likely be macro, as it relates to the manifestation of a credit cycle downturn that is not currently being priced into equities right now. We would need to see price break below $260.50 in the coming summer volatility. If this happens, then we will be targeting a retest of the January lows.

Red – On the other hand, this 3-wave move off the January low, can turn into a 5 wave move. This would require the summer volatility to hold within the green target box below, and then turn back up to make a fresh high. If this happens, then THE low is likely in for MSFT. 

Our buy plan is to accumulate based on both scenarios playing out. So, we will start adding to our position in the $300 – $265 region.

We share buy plans such as this one every week in our premium webinars held on Thursdays at 4:30 pm EST. We also issue real-time trade alerts when we do buy and are one of the only audited portfolios available to retail investors. Our performance exceeds institutional all-tech portfolios. Learn more here.Learn more here.

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Microsoft – AI Will Help Drive $100 Billion In Revenue By 2027

Posted on by io-fund

This article was originally published on Forbes on Jun 15, 2023,11:18pm EDTForbes Forbes on Jun 15, 2023,11:18pm EDT

Given the runup in AI-related valuations, separating the real deal from companies that are merely AI wannabes is critical. The first few things to consider are, will this company see revenue from AI and, if so, how soon.

AI-related cloud stock chart

Source: YCHARTS

Although many AI stocks will not report enough AI revenue to survive the fierce, competitive battle the tech industry faces due to AI/ML, Wall Street investors can reasonably assume that Microsoft will be a leader in this space. Microsoft’s AI platform is rather insulated from widespread competition outside of Google Cloud and AWS, and the company’s software assets are particularly well suited for AI advancements, such as Office 365.

In April of 2022, our firm re-entered Microsoft with a note to our premium research members about the company’s dominance in AI before Chat-GPT3 was released. We repeated this in October of 2022 when we called Microsoft a “sleeping AI giant”:

“Microsoft is a sleeping AI/ML giant. Google gets a lot of attention here yet I think they are equally prepared to serve this market […] To help Microsoft rival Google, the company has been investing in OpenAI, which is a large R&D operation that is breaking ground with AI algorithms that help computers to create images from text, reduce the amount of code that developers need to write, and to also help robotics think and act like humans, among other things […] DALL-E is a “12-billion parameter” version of GPT-3 that creates images from text. The partnership with Microsoft will bring DALL-E to apps and services, including the Designer app and Image Creator tool in Bing and Microsoft Edge – this was announced earlier this month at Ignite.”

Analysts have been raising their price targets to the high $300s with an Evercore analyst raising his price target to $400 stating: “the infusion of AI across Microsoft’s product portfolio represents a potential $100 billion incremental revenue uplift in 2027.”

To provide some context, Azure and Office 365 helped Microsoft add almost $100 billion in revenue over the past four years. It increased from $110 billion to $198 billion in revenue. The stock appreciated 180% over that time frame. At the time, the market did not comprehend the revenue potential in these two businesses. We believe that history will repeat itself and the market is underestimating the impact AI will have on MSFT’s future sales growth across its business lines.

However, valuation poses a risk to Microsoft’s current stock price, and as outlined below, our firm prefers to wait before we add again to our position.

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6 Ways Microsoft Can Drive Another $100 Billion with AI:

Open AI APIs:

The OpenAI opportunity extends beyond Microsoft’s installed base, which is an important change to Microsoft’s market position. This is because OpenAI APIs run on Azure even if the customer isn’t directly an Azure customer. Management commented on this in the earnings call:

“Second, even Azure OpenAI API customers are all new, and the workload conversations, whether it's B2C conversations in financial services or drug discovery on another side, these are all new workloads that we really were not in the game in the past, whereas we now are.”

Generative AI for Government:

One market that gets overlooked in terms of its AI impact is the Federal Government. It is currently undergoing a major shift into the cloud. In a blog post, the company CTO Bill Chappell wrote: "Microsoft continues to develop and advance cloud services to meet the full spectrum of government needs while complying with United States regulatory standards for classification and security. The latest of these tools, generative AI capabilities through Microsoft Azure OpenAI Service, can help government agencies improve efficiency, enhance productivity, and unlock new insights from their data. Many agencies require a higher level of security given the sensitivity of government data. Microsoft Azure Government provides the stringent security and compliance standards they need to meet government requirements for sensitive data."

Many years ago, I wrote about the Pentagon contract and why Microsoft would be a front runner when it was widely reported AWS was the sole Big 3 contender for the contract. This analysis pointed toward the long-standing history Microsoft has in being favored by government entities.

Microsoft CoPilot:

The company introduced Microsoft 365 Copilot last month. It is the productivity tool that combines large language models (LLMs) with the data in Microsoft Graph and Microsoft 365 apps. The use cases of Copilot in Word include giving the users the first draft while saving the time on sourcing, writing, and editing the content. Similarly, Copilot in PowerPoint will help to create presentations based on previous content. Copilot in Excel can analyze trends from the data, create charts, and helps to make informative decisions.

To have a suite of productivity products that can see an immediate impact from AI-related R&D is a large part of the $100 billion that Microsoft can potentially add to the top line by 2027.

Edge/Telecom Partnerships:

Another important driver is Microsoft’s close partnerships with many of the telecom and data centers around world which will further cement its strong position in edge computing.

In February, Microsoft announced it had previewed two AI-powered services that are designed to manage telecom networks. Jason Zander, executive vice president of strategic missions and technologies at Microsoft said, “What we’re doing is taking our native cloud work and making it specific to this telecom operator network space. I think a really great example of that is all the AI ops work that we are introducing into the system."

Microsoft Bing:

In the most recent quarter, Microsoft announced that the new AI-powered Bing and Edge has seen a positive response. The company crossed 100 million daily active users of Bing. This is how Microsoft described the early impact of ChatGPT.

“Of the millions of active users of the new Bing preview, it’s great to see that roughly one third are new to Bing. We see this appeal of the new Bing as a validation of our view that search is due for a reinvention and of the unique value proposition of combining Search + Answers + Chat + Creation in one experience.”

Notably, Microsoft Bing has 3% market share and for every additional 1%, Microsoft will make an additional $2 billion.

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Microsoft is one of the largest cybersecurity companies

Microsoft’s cybersecurity segment reports more than $15 billion in revenue. The company was also the only Big 3 cloud vendor to not only build a multi-cloud product but also multi-cloud security. Today Microsoft’s cybersecurity sales dwarf the revenue of many cybersecurity best-of-breed products combined.

Cybersecurity sales chart

Source: I/O FUND

Installed customer base provides cross selling opportunities for new AI/ML based products and functionality

In the spring of 2022, I wrote about how reducing cloud costs was going to be a key trend in 2022 and beyond. We believed that Microsoft was uniquely positioned to benefit from this trend as it aggregates cloud services to help drive down costs. This is especially attractive for the Fortune 500 whereas startups, SMBs and mid-sized enterprises are likely to seek out and manage a larger portfolio of cloud services from various vendors.

Among the Big 3, Microsoft dominates the Fortune 500 with 95% running on Azure. Retaining the Fortune 500 in the migration to the cloud was accomplished through hybrid computing where Microsoft was first-to-market on serving a mix of on-premise, private and public clouds for their large enterprise customers. As the leader in on-premise systems, Microsoft was perfectly positioned to win with hybrid architectures. The company took this a step further and undercut other services on prices across its suite of software and platforms to win aggregate, long-term contracts.

Microsoft’s Risk is Valuation

Microsoft business model is low risk compared to many other AI stocks. However, there is certainly risk in the company’s valuation. The risk is compounded when market exuberance front runs a trend and overshoots the mark of what a company can realistically report in the coming years. Microsoft’s valuation is high relative to its 5-year median. If you look at the 5-year median prior to the current runup, the stock has a historic valuation of 9 PS Ratio and is currently trading at a 12 PS Ratio. Similarly, the 5-year median PE Ratio at the start of the year was 25 and the stock is currently trading at 36.

Microsoft PS Ratio

Source: YCHARTS

Conclusion:

AI will be a constantly evolving space and while many investors are rushing in at overstretched valuations, we prefer to be patient. Over time, we agree with the analyst that Microsoft’s competitive moat has positioned it to monetize the AI opportunity, much like with Azure and Microsoft 360, across its business lines so that its revenue will increase by $100B in the medium-term.

Microsoft is a real-deal AI stock and the increase in valuation has clearly factored in some of this. However, our updated sum-of-the parts analysis indicates there is still upside. Our current bull case price target is $440. As the story unfolds over the next few quarters, we see additional upside. However, in light of the strong rally from the Jan 2023 lows, we believe incorporating technical analysis to attempt to get the stock lower is important in determining optimal entry levels. In other words, the risk the stock sells off is much higher than usual right now. Sure, the stock price could continue to climb higher, but the world’s best investors favor being patient and buying when the market is in a state of fear rather than a state of greed. When we do add to our key positions, we issue real-time trade alerts. Learn more here.

Please note: The I/O Fund conducts research and draws conclusions for the Fund’s positions. We then share that information with our readers. This is not a guarantee of a stock’s performance. Please consult your personal financial advisor before buying any stock in the companies mentioned in this analysis.

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