July 24, 2024

Microsoft’s near-term fate is in OpenAI’s hands — for better or worse

When OpenAI descended into boardroom-battle-chaos right before Thanksgiving, Microsoft (MSFT) was immediately in the crosshairs.

The software giant had already thrown in its lot with OpenAI, incontrovertibly and initially to much fanfare. Microsoft first invested $1 billion in OpenAI in 2019, then upped the ante in January with another $10 billion. In total, Microsoft’s investment in OpenAI is reportedly worth as much as $13 billion, albeit with mysterious and unorthodox terms.

The ousting of OpenAI CEO Sam Altman highlighted a salient reality — that Microsoft’s near- and long-term fate in the AI arms race lies squarely with OpenAI.

In part, there’s a simple reason for that — Microsoft doesn’t have a bona fide exit strategy. Its OpenAI investment reportedly includes limited cash, and lots of Azure cloud credits.

Additionally, Microsoft reportedly doesn’t actually own a stake in OpenAI, in the traditional sense. Instead, the software company is entitled to around half of OpenAI’s financial returns until a portion of the investment is repaid.

But more importantly, OpenAI is the core of Microsoft’s plan, in a race where competitors are gaining ground.

“If Microsoft’s relationship with OpenAI was severed or OpenAI disappeared, then it would set them back,” said DA Davidson analyst Gil Luria. “The rate of progress on this technology, and the rate at which they’re transforming their business around that technology is such that they don’t want to deal with any disruption.”

The new path to the tech kingdom is through artificial intelligence, and for Microsoft, OpenAI holds the key.

While rivals Google (GOOG, GOOGL) and Amazon (AMZN) were punished by investors when they reported lackluster cloud numbers in October — despite beating earnings estimates overall — Microsoft earned accolades for exceeding expectations with its cloud unit. Its shares opened nearly 5% higher on October 25, the day after it reported its earnings after hours.

Microsoft’s stock has rocketed up 57% this year, outpacing S&P 500’s 25% gain. It’s currently trading at around 33x forward earnings, according to Yahoo Finance data, compared to 20x for Google.

“They’ve been seen as an innovator in the hottest area in tech, and the stock price has shown that this year,” Steve Sosnick, chief strategist at Interactive Brokers, told Yahoo Finance. “But long-term, we’re still far from knowing who the winner is.”

Holding on to that lofty valuation would require continuous advancements in Microsoft’s AI offerings and cloud earnings. It launched its Copilot portfolio, a series of AI assistants powered by OpenAI’s GPT-4, in November.

Subscriptions to the AI bots could add $9.1 billion in sales by fiscal year 2026, Macquarie’s Head of AI & Software Research Fred Havemeyer told Yahoo Finance Live.

“What OpenAI did is it helped them finally become relevant in search, after years of also-ran,” said Sosnick.”If Bing with ChatGPT can eat into Google’s market share for search, on its own, the investment more than justifies itself.”

But the competition for AI products is fierce. Google launched Duet AI for Google Workspace in late August, and Amazon Web Services (AWS) introduced its enterprise AI chatbot, Amazon Q, in late November.

Where rivals like AWS is offering generative AI platforms compatible with multiple large language models (LLMs) from Anthropic, Cohere, Meta, and more, Microsoft has bet the house on OpenAI.

That made solving the OpenAI crisis essential to its immediate future. So far, CEO Satya Nadella has passed the mark.

“Nadella is a chess master,” said Luria. “This will be a chapter in the authorized biography of Satya Nadella… He continues to do all this with humility. There’s never the pomp and arrogance that you see from a lot of other tech leaders.”

Tola Capital partner Sheila Gulati, a former Microsoft executive who worked with Nadella for years, credits Nadella’s leadership style for successfully navigating the OpenAI drama.

“His style is that you’re going to get along with the rest of the team, work together, be consultative, and helpful, and I’m going to listen — and listen deeply,” said Gulati. “He wants to get the best out of you, and then he’s decisive.”

Taking a hard left now from OpenAI would be fraught with challenges. Even the in-the-moment solution that Nadella came up with — directly hiring Altman and OpenAI President Greg Brockman — wasn’t without its complications.

“Microsoft could have just hired everybody… [but] building something new, that’s still hard,” said Luria.

Ultimately, Microsoft picked OpenAI for its top dog status, but may need to diversify sooner rather than later, especially if competitors catch up.

“Right now, they’ve hitched their star to the leader, and that’s to their benefit,” said Sosnick. “The question now is whether OpenAI can retain that status… They made a huge investment in an unconventional organization and that carries risk.”

Lingering concerns

Microsoft's CEO Satya Nadella speaks at the Asia-Pacific Economic Cooperation (APEC) CEO Summit in San Francisco, California, U.S., November 15, 2023. REUTERS/Carlos Barria

Microsoft’s CEO Satya Nadella speaks at the Asia-Pacific Economic Cooperation (APEC) CEO Summit in San Francisco, California, U.S., November 15, 2023. REUTERS/Carlos Barria (REUTERS / Reuters)

Moving forward, concerns about OpenAI will be front and center for shareholders. For one, like many big-name AI startups, there are bubble and valuation fears.

“I think there is awareness that there is a bubble, and that can either lead to fear or encourage investors to further expand the bubble,” said PitchBook analyst Brendan Burke.

Traditional valuation metrics have flown out the window. Prior to the boardroom drama, OpenAI was reportedly seeking a $86 billion valuation, after fetching a $29 billion valuation in April.

A source told Yahoo Finance that OpenAI shares were among the most in-demand on the secondary market before the boardroom drama. Upon the initial announcement of Altman’s departure, transaction volume tanked.

That sort of precipitous decline is only something the source has seen in comparatively unflattering situations, like FTX and WeWork.

Though the value of OpenAI has recovered — the source said secondary transactions now give the company an implied valuation of $100 billion — the buyer interest is only about half as much as early November. Some of the demand has been funneled into other AI startups like Anthropic and Cohere; Microsoft has not made its platform compatible with their LLMs.

But OpenAI’s asterisks and assets are Microsoft’s problem now.

The two companies are linked in a union that’s oddly akin to a couple who had a shotgun wedding. They’re learning about each other in the aftermath of the honeymoon, and are stuck, semi-literally, for richer and for poorer, and in sickness and in health.

“There’s natural limitations on growth in a company as big as Microsoft, so if finding growth requires doing things in an unusual manner, they should do so,” said Sosnick.

“But the risk, in the end, is the same as any innovator in any technology — rivals can sneak up on you by doing it a better way… Yes, diversification can help, but if you partner with five also-rans, that also doesn’t help you,” said Sosnick.

Allie Garfinkle is a Senior Tech Reporter at Yahoo Finance. Follow her on X, formerly Twitter, at @agarfinks and on LinkedIn.

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