Microsoft & OpenAI – Chinese whispers.

This is not a simple $10bn investment.

• Microsoft is deepening its ties with OpenAI which looks to me to be mostly about cementing Azure’s edge over AWS in that Microsoft has exclusive access to the hottest AI property on the market right now.
• Microsoft has said that it is making a “multiyear, multibillion-dollar investment to accelerate AI breakthroughs” and that it will increase “investments in the development and deployment of specialized supercomputing systems to accelerate OpenAI’s ground-breaking independent AI research”.
• It does not say “we are investing $10bn to buy OpenAI shares at a pre-money valuation of $29bn”.
• Hence, I think that this deal is far more complicated than the straight investments it did in 2019 and 2021.
• Furthermore, if it was investing $10bn in OpenAI shares, this would represent a very material transaction and Microsoft would be obligated to disclose this fact to the market as it is a public company.
• Consequently, I think that the following makes the most sense for Microsoft.
  • First, exclusive: Microsoft makes a further investment in OpenAI in order to help finance the AI research upon which OpenAI is engaged.
  • This is probably in the form of $2bn – $4bn and comes with all sorts of preferences that ensures that Microsoft will be able to earn back its investment over time.
  • OpenAI is supposed to be a non-profit which in hard financial numbers means that the value of the company (present value of the discounted free cash flow) should be $0.
  • Hence, what I suspect Microsoft is buying is an exclusive right to use OpenAI’s technology in its products as well as the promise that OpenAI will only use Azure’s cloud infrastructure.
  • The majority of that investment will end up coming back to Microsoft anyway in the form of Azure revenues as OpenAI subscribes to the massive compute approach to solving AI (see here).
  • Second: Servers: I think the rest of the money will be spent on building custom infrastructure that will run OpenAI’s technology optimally both in terms of performance and power consumption.
  • Because the servers are customised, they will not run other systems particularly well creating an interdependency between the two companies.
  • The popularity of ChatGPT has meant that during busy times, response times increase materially, implying that there is not enough hardware to run the level of requests that are coming in.
  • If Microsoft is going to use OpenAI in its commercial products (see below), then it will not be able to afford to have service slowdowns or outages as a result of high demand.
• I see two main benefits from this deal for Microsoft.
  • First, Azure differentiation: This deal will very likely ensure that OpenAI will not be available on AWS, Google Cloud or anyone else.
  • This means that Azure will be able to offer OpenAI as a service to its customers (eg Azure OpenAI Service (see here))which is a feature that AWS will be unable to replicate.
  • Should OpenAI’s products become popular with clients, this will give Azure firepower in its quest to close the gap on AWS.
  • Second, new products: Microsoft will have the ability over time to embed OpenAI into its other products such as Office and Windows which may help them to improve.
  • My experience with AI in both Windows and Office 365 to date has been mild irritation leading to it being disabled, meaning that its value to me has been negative.
  • There are many areas where Microsoft products could be greatly improved by AI (eg search in Outlook) and OpenAI may be able to help in these areas.
  • I do not expect to see ChatGPT embedded in Office as I don’t think that it is either trustworthy or safe meaning that it fails Microsoft’s own standards for AI products that it creates.
• Hence, I think that this deal structure is very far from that being reported in the media and technology press but it is one that makes much more rational sense than just dumping $10bn into OpenAI at $29bn.
• There has been substantial chatter over the last few weeks on this issue and so I suspect that the reality of the deal has been distorted as the news passes from one source to another.
• If OpenAI products can be made trustworthy and safe, then Microsoft stands to benefit from this transaction in the long term, but I can’t see this as a reason to get excited about the shares now.
• The market is slowing as Microsoft’s 10,000 layoffs suggest meaning that the shares continue to look fully valued pushing me to look elsewhere.