The rise of artificial intelligence (AI) has created a handful of absolutely massive companies. Just three years ago, one company, Apple, sported a market cap exceeding $2 trillion. Today, five companies are worth more than that, and Nvidia has climbed to a $4.56 trillion valuation.
The GPU giant is unlikely to remain alone in the $4 trillion club for long. Apple is knocking on the door at $3.83 trillion, and Microsoft (MSFT 0.26%) is even closer at $3.84 trillion. In fact, the average analyst on Wall Street expects Microsoft to reach a valuation of around $4.7 trillion within the next year.
Here are three reasons why analysts are so bullish on Microsoft right now.
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1. Microsoft has a big revenue pipeline
At the end of its most recent quarter, Microsoft reported remaining performance obligations totaling $368 billion. That backlog of contracts is tied to both its Azure cloud computing platform and its commercial software and services like Microsoft 365. It's also a 37% increase from a year ago.
That's strong growth for Microsoft, with its backlog growth keeping pace with its smaller rival Alphabet (GOOG 0.01%) (GOOGL -0.16%) and outpacing Amazon (AMZN -1.34%). That said, Microsoft's numbers suggest more of its backlog is held in long-term contracts relative to Amazon or Alphabet. Still, it means Microsoft can keep growing revenue for years to come.
It's worth noting that Microsoft's partnership with OpenAI gives it the right of first refusal for its cloud computing business. That means OpenAI came to Microsoft with its $300 billion spending proposal before it went to Oracle (ORCL -0.89%). Microsoft's decision to refuse the contract is a sign that it has plenty of demand for the amount of capacity it can bring online in that time. It also means Microsoft can diversify its customer base, so it doesn't become overly reliant on OpenAI to drive revenue growth.
While Oracle's backlog has technically grown larger than Microsoft's with the OpenAI deal, Microsoft's position still looks stronger.
2. A massive cash cow business supporting its growth
Despite the fact that Microsoft has become a cloud computing giant, its enterprise software business is still a bigger source of revenue (for now). Productivity and Business Processes revenues climbed 16% last quarter, generating over $33 billion in sales.
Moreover, the segment, along with its More Personal Computing segment containing Windows and its devices, is a huge cash cow. While Microsoft is sinking tens of billions of dollars into data centers for Azure, it's still able to generate tens of billions in free cash flow. Last quarter's free cash flow of $25.6 billion was an all-time high despite spending over $24 billion on capital expenditures.
Microsoft continues to increase its capex, with plans to spend $30 billion this quarter. But it should generate more than enough cash to ensure it can continue paying out a dividend and buying back shares with plenty of cash left over for acquisitions and investments. By comparison, Oracle will have to raise debt to build out its cloud infrastructure as it produces negative free cash flow. Additionally, Microsoft's free cash flow now exceeds both Alphabet's and Amazon's on a trailing-12-month basis while spending more on data centers.
3. Microsoft is well-positioned to monetize generative AI
Microsoft's entrenchment in enterprise operations gives it multiple opportunities to monetize AI services across its segments.
The company sports over 430 million Microsoft 365 users, and that number's growing steadily. That's a huge user base for it to sell its Copilot AI services. Microsoft also offers Copilot Studio to extend the functionality of its Microsoft 365 Copilot and create custom AI agents using proprietary data and custom workflows. As of the end of last quarter, management said it had 100 million total Copilot users, including 20 million GitHub Copilot users. So, there's still plenty of growth left.
On top of that, Microsoft is well-positioned to capitalize on AI capabilities within Azure as it migrates more enterprises to the cloud. With most businesses using Windows, Azure offers a seamless transition for many systems, and it can support more hybrid cloud computing setups. Microsoft can use AI services in Azure as another selling point to accelerate the transition to the cloud while increasing contract sizes.
AI should support strong revenue growth across Microsoft's main segments for years to come. Combined with its growing free cash flow and massive backlog, the stock should continue to climb higher from here.
