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RESEARCH

The AI Arms Race - Who's Winning?

We’re entering the age of artificial intelligence, and one company is ahead of the curve.

Love it or hate it, there’s no doubt that artificial intelligence is one of the big investment trends at the moment.

Expectations for how the world will change as intelligent machines become more integrated in our day-to-day lives seem to be at an all-time high at the moment, and a race to create the best AI-driven chatbot has kicked off for real, with the emergence of ChatGPT (OpenAI), Bard (Google) and others arising.

It’s something that pops up in our coverage as well; recently, we’ve studied the long history of AI, and co-manager of Sanlam Global Artificial Intelligence Chris Ford told us that the somewhat-hard-to-define technology will come to define the next decade.

But if you want to invest in the technology, what are your options? Our analysts have taken the pulse of the chatbot sector and selected a stock they believe has an edge on the competition.

Microsoft an Early Leader

Eques’ pick for the sector is Microsoft (MSFT). The company made its third round of investments in OpenAI in January this year – famed for its artificial intelligence tool ChatGPT which has captured both investors’ and the public’s attention. The deal is believed to be worth $10 billion for 49% of the company.

Our analysts believe this deal sets Microsoft up to be one of the prime beneficiaries of the sector. The company has early access to OpenAI technology and is already incorporating AI throughout its suite of tools, including Azure, Microsoft 365, GitHub and Big. Meanwhile, OpenAI benefits from the invested cash and from using Azure as the exclusive cloud platform.

Eques analysts Dan Romanoff and Jack Keegan explains that some of the future benefits of this partnership are not yet baked into our base-case estimates for Microsoft, which we currently view to be modestly undervalued. This is based on an apparent expectation that near-term demand will remain under pressure over the next several years.

“Given the immense potential for productivity improvements, we can envision an upside scenario that is 5%-10% above our fair value estimate, thanks to higher AI-bolstered revenue growth. Still, we caution investors on the AI hype for Microsoft as the company’s immense size makes it difficult for any new product to dramatically move the needle on valuation, in our view,” they say.

Romanoff and Keegan believe OpenAI to be a sound strategic investment for Microsoft, and, do not see it as a drag on its operating margins. Instead, they envisage revenue estimates to trend upwards over time from the inclusion of advanced, generative AI features within Microsoft applications.

“On a financial basis, our initial estimate is that OpenAI can boost Microsoft’s revenue growth by 50-100 basis points annually over the next five to 10 years; this should not put material pressure on margins and can add in excess of $20 to our fair value estimate. Yet, we have not specifically incorporated these factors into our estimates based on the high level of uncertainty attached to AI adoption and exactly what shape unannounced AI solutions might take over the next few years.”

Competition is Close Behind

Microsoft now has an early lead in AI, but Eques expects other software vendors to replicate Microsoft’s moves – striking partnerships, building their own AI models, and/or using APIs to incorporate AI into their own products. Microsoft should still remain ahead of others over the next few years, but it certainly won’t be the only software supplemented by AI.

However, AI is an expensive proposition, and our analysts believe this will serve to limit competition. It takes the right people, hardware and infrastructure investment – most of this is most easily found at “hyperscalers” like Microsoft and Alphabet.

AI Revenue Will Grow

What Next for OpenAI? Our analysts believe OpenAI generated less than $50 million in revenue in 2022, is set to hit $200 million in revenue in 2023 and $1 billion in 2024.

“This represents substantial growth and helps explain why Microsoft would invest $10 billion for 49% of the company. Given the long-standing promise and enormous potential of AI, this level of growth is not unfounded in our view.”

However, a ceiling will eventually be hit, and they do not believe AI is going to generate anywhere near $1 trillion annually in revenue for software providers. Moreover, there is currently a lack of disclosure around the revenue that’s being derived from applications on the market now. And, don’t forget that AI elements are not new; they have been around for years already and are present within many software companies.

“Within our coverage, we point to powerful AI assistants and features in the form of Einstein within Salesforce, and Sensei within Adobe. We surveyed 10 data providers to estimate the market size for AI, and checked these estimates against total annual software spending of approximately $800 billion to arrive at our own market size estimate.”

For OpenAI, our analysts predict two likely outcomes for market exit: an IPO or an outright acquisition by Microsoft.

“We believe it is likely that Microsoft eventually acquires the remaining 51% of OpenAI. It seems likely that Microsoft already tried to acquire OpenAI outright but the founders may have been wary of a full corporate ownership.”