Microsoft & Meta – Headline With AI

Both relatively immune from the DeepSeek effect.

Microsoft FQ2 25 – DeepSeek on the menu

• Microsoft disappointed the market with the growth of its cloud division but as the reason for this was supply constraint rather than demand, this is hardly an issue to get too worried about.
• FQ2 25 revenue / EPS came in at $69.6bn / $3.23 broadly in line with consensus estimates of $68.9bn / $3.12.
• AI was unsurprisingly the engine of growth with Azure AI services growing 157% YoY (a large part of which was OpenAI) to an annual run rate of $13bn or $3.25bn in actual revenues.
• However, in the non-AI services, problems occurred with customers who buy Microsoft products through partners where Microsoft’s visibility on the scale and nature of their demand is not particularly good.
• This small aberration was the cause of concern, and the shares fell 4% in after-hours trading which I think will soon be corrected.
• Translating Ms Hood’s corporate speak into plain English leads me to interpret the problem as Microsoft not correctly anticipating where the demand would occur and investing in the wrong place.
• This is not a big deal in my opinion and given Microsoft’s recent history in execution, I think this problem will rapidly be solved.
• Microsoft is addressing the DeepSeek issue by offering the model on Azure for those who want it and highlighting that cheaper AI means more demand as one would reasonably expect.
• I continue to think that the CCP will not be keen to simply give away the fruits of DeepSeek’s labours and would not be surprised to see that the huge cost reductions prove difficult to replicate outside of DeepSeek’s infrastructure.
• This is why I continue to view DeepSeek’s innovations in terms of cost reduction and efficiencies with a healthy dose of scepticism and I await independent verification.
• From Microsoft’s perspective, cheaper AI represents more adoption and in the long run, higher revenues and profits which is why we have not seen the shares spooked by DeepSeek’s products and claims.
• However, this leaves the shares on a pretty full valuation of FY2025 PER of 33.9x, meaning that there is better value to be had elsewhere.

Meta Q4 24 – Profit powerhouse.

• Meta has finally put the AI bugbear behind it as it is clear that Meta is now able to use AI to run its own operations more efficiently and for a company already present in the open-source community, DeepSeek is more of an opportunity than a threat.
• FQ4 revenues / Adj-EPS were $48.4bn / $8.02 nicely ahead of estimates of $47.0bn / $6.76 as cost reductions in legal accruals and restructuring more than offset headcount growth in R&D and infrastructure expenses.
• These reductions have now largely come to an end and Meta is likely to invest in line with revenue growth going forward.
• With operating margins of 48%, despite a colossal $5.0bn (-458% EBIT margin) loss from Reality Labs demonstrates just how profitable (59.9% EBIT margin) the core business is which puts Meta in a superb position to invest.
• This is a testament to Meta’s efforts over the last 5 years in AI which have seen to evolve from a laggard into one of the leaders.
• The threat to Meta from DeepSeek is real in that Meta is currently the standard for open-source AI and if DeepSeek proves much cheaper to train and run than Llama, then that position may be meaningfully challenged.
• However, the geopolitical environment means that trust in China as a good actor is at rock bottom meaning that many developers outside of China will be wary of using DeepSeek as a foundation and becoming dependent on it.
• The small print also indicates that any data that is run through R1 will end up in China which will increase concerns still further.
• This does not mean that open source copies of the model that are downloaded and finetuned will send data to China but with 671 parameters in the model there are lots of potential hiding places for backdoors and other covert functions.
• If Meta can replicate DeepSeek’s innovations (big if), then it stands to benefit as it will be able to offer its services and run its business at a lower cost than previously.
• Hence, I think that the threat to Meta from DeepSeek is low and Meta way well be able to turn its innovation to its advantage.
• At 28.9x 2025 PER, the value story of Meta has long since been priced in, meaning that future performance is likely to be a function of fundamentals rather than a rerating by the market.
• Hence, this is another one where the easy money has been made and as such, I remain fairly indifferent to the shares with much better value available elsewhere.