Artificial Intelligence (AI) is a hot topic which has a tremendous amount of potential, as big data can be harnessed for a variety of applications from generative text to process optimization. Forecasts from Statista indicate blistering growth in the industry from ~$200 billion in 2023 to a staggering $1.8 trillion by 2030. Not every business in the industry will be successful, but there are already some companies that have recently beaten quarterly earnings and revenue forecasts on the back of strong AI tailwinds. Two of the most notable ones in my opinion are Microsoft (MSFT, Financial) and Palantir (PLTR, Financial); let’s dive in.
Microsoft
Global technology giant Microsoft (MSFT, Financial) is poised to be a major beneficiary and driver of the AI industry on several fronts. The company was an early backer of OpenAI (which created ChatGPT) and recently invested $10 billion to gain a stake of 50% in the business. In addition, Microsoft's cloud platform Azure is the second largest cloud infrastructure provider in the world and a leader in AI supercomputing.
Microsoft’s CEO Satya Nadella recently forecast that “every app will become an AI app” and the company has integrated AI into a variety of its products. Examples include its enhanced Bing search engine, as well as “Copilot” AI integrations with Microsoft Word, Powerpoint, Outlook and even Teams.
Financial firepower
Microsoft reported super financials for its third quarter of fiscal year 2023. Its revenue was $52.86 billion, which beat analyst estimates by $1.8 billion and rose by 7% year over year. This growth rate may not seem incredibly fast, but it was actually greater than the prior quarter's growth rate of just 1.97% year over year. Therefore this could be an indication a possible turnaround is pending.
This was driven by solid growth in its Intelligent Cloud segment, which increased by 16% year over year to $22.1 billion. This was also enhanced by the aforementioned AI tailwinds with its Azure OpenAI customer base increasing to 2,500, up 10-fold relative to the previous quarter.
Microsoft’s Productivity segment also reported strong results with 11% year over year growth to $17.5 billion. This was driven by continued adoption of its Office 365 suite, which increased its revenue by 14% year over year. Previously I thought Microsoft was losing its competitive advantage with regards to the Office applications given competition from free platforms such as the Google documents suite. However, the planned integration of AI into its products could help to bolster its adoption and should enable it to remain “sticky” especially with its enterprise customers.
The world's largest work-based social network LinkedIn has also continued to produce solid growth, increasing revenue by 8% year over year. I believe this platform will also continue to grow as it doesn’t face the type of competition we see in the social networking platforms,
Microsoft’s PC and gaming revenue is still struggling, with its “More Personal Computing” segment reporting a 9% decline in revenue to $13.26 billion. A positive is this looks to have been caused mainly by a cyclical industry decline in the computing market, after a major boom in 2020 and 2021. Therefore I don’t believe Microsoft will suffer too much long term.
In terms of profitability, Microsoft reported earnings per share of $2.45, which beat analyst forecasts by $0.21 in the quarter.
The company also has a formidable balance sheet with $104.4 billion in cash and short-term investments compared to total debt of $79.2 billion.
Valuation
Microsoft is a tremendous company, but its share price has increased by a staggering 38% between January and May 2023. Therefore, one would assume its valuation gap has begun to close. In fact, Microsoft trades at a price-earnings ratio of 32, which is 8.8% higher than its five-year average.
A positive is the GF Value chart indicates the stock is “fairly valued” at the time of writing.
Palantir
The other AI stock that recently beat earnings is Palantir (PLTR, Financial), a company that one may not initially assume is a major player in AI as it is mostly making headlines for its defense applications and mass surveillance programs. However, the company was in fact rated as a “leader” in AI and Machine Learning (ML) platforms by Forrester in 2022. The software company has recently launched a new AI platform for both its commercial and defense customer base.
I believe Palantir has huge potential to grow beyond defense and help enable enterprises to adopt AI, as the company has existing relationships with customers across a variety of sectors from oil and gas to health care.
On the defense side, Palantir was originally backed by the CIA and has customers such as the U.S. Army and the U.K. Royal Navy. Its business still mainly revolves around defense, though Palantir is trying to divert from that not just for business expansion but also for public relations reasons.
Improving financials
Palantir has previously been criticized for its slowing growth and lack of profitability, but now these factors look to be turning around. The company reported $525 million in revenue for the first quarter of 2023, which surpassed analyst estimates by over $19 million and grew by 15% year over year.
The company reported solid overall U.S. revenue growth, which rose by 23% year over year to $337 million. Its U.S. government revenue also increased by a solid 22% year over year to $230 million. I believe this is a positive sign as government agencies tend to be more “sticky” as customers and also offer huge account expansion opportunities.
Palantir also reported solid profitability improvements with earnings per share of $0.01, which beat analyst forecasts by $0.02. This was Palantir's first profitable quarter on a non-adjusted basis, which is a positive sign especially given the declining economic environment.
This was driven by improved economies of scale, specifically relating to its general and administrative expenses. In addition, the company reported improvements in its stock-based compensation as a portion of revenue.
The business also has a fortress balance sheet to continue to invest in AI technology and future growth. Palantir reported $2.9 billion in cash and marketable securities, with approximately $249 million in total debt, which is manageable.
Valuation
Palantir's stock skyrocketed by ~16.54% after the company announced solid earnings for the first quarter. Despite this, the business still trades at a forward price-sales ratio of just 9, which is ~30% cheaper than its five-year average.
Therefore, I believe Palantir looks to be reasonably priced despite the major bull run and hype surrounding the AI industry. However, prudent investors may wish to wait for a pullback or higher profitability.
Final thoughts
Both Microsoft and Palantir are two tremendous companies that are poised to benefit from growth in the AI industry. Microsoft is in the most dominant position due to its vast scale, supercomputing cloud infrastructure and investments into OpenAI. However, Palantir also offers huge potential, especially in the defense industry, which is looking for a secure way to adopt AI technology at scale in order to improve mass surveillance, crime prediction algorithms and defense operations. Both companies have beaten earnings expectations recently and are not too expensive. They are not really “cheap” either, but personally, I would consider them around fair value for a growth investor.
