When OpenAI entered the boardroom chaos just before Thanksgiving, Microsoft (MSFT) was immediately in the crosshairs.
The software giant had already undeniably and initially with much fanfare joined OpenAI. Microsoft first invested $1 billion in OpenAI in 2019, then upped the ante by another $10 billion in January. In total, Microsoft's investment in OpenAI is reportedly worth as much as $13 billion, albeit under mysterious and unorthodox terms.
The ousting of OpenAI CEO Sam Altman highlighted a striking reality: that Microsoft's short- and long-term fate in the AI arms race rests squarely with OpenAI.
In part, there's a simple reason for this: Microsoft has no bona fide exit strategy. The OpenAI investment reportedly includes a limited amount of cash and a lot of Azure cloud credits.
Furthermore, Microsoft reportedly doesn't actually own a stake in OpenAI, in the traditional sense of the word. Instead, the software company is entitled to about half of OpenAI's financial returns until some of its investment is repaid.
But more importantly, OpenAI is at the heart of Microsoft's plan, in a race where competitors are gaining ground.
"If Microsoft's relationship with OpenAI were to end or OpenAI were to disappear, that would put it at a disadvantage," said DA Davidson analyst Gil Luria. "The speed at which this technology is advancing, and the speed at which they are transforming their business around that technology, is such that they don't want to deal with any disruption."
The new path to the technology kingdom is through artificial intelligence, and for Microsoft, OpenAI is the key.
While rivals Google (GOOG, GOOGL) and Amazon (AMZN) were punished by investors when they reported lackluster cloud numbers in October - despite beating earnings expectations overall - Microsoft won praise for beating expectations with its cloud unit. Its shares opened nearly 5% higher on Oct. 25, the day after it reported its after-hours earnings.
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Shares of Microsoft are up 57% this year, outpacing the 25% gain in the S&P 500. According to data from Yahoo Finance, it currently trades at about 33x forward earnings, compared to 20x for Google.
"They are seen as an innovator in the hottest area of technology, and the stock price has demonstrated that this year," Steve Sosnick, chief strategist at Interactive Brokers, told Yahoo Finance. "But in the long term, we still don't know who the winner is."
Maintaining that high valuation would require continued progress in Microsoft's AI offerings and cloud revenues. It launched its Copilot portfolio in November, a suite of AI assistants powered by OpenAI's GPT-4.
Subscriptions to the AI bots could add $9.1 billion in revenue by fiscal year 2026, Macquarie's Head of AI & Software Research Fred Havemeyer told Yahoo Finance Live.
"What OpenAI did is it helped them finally become relevant in search results after years of being there as well," Sosnick says. "If Bing can alone eat into Google's market share for search with ChatGPT, the investment more than justifies itself."
But competition for AI products is fierce. Google launched Duet AI for Google Workspace in late August, and Amazon Web Services (AWS) introduced its business AI chatbot, Amazon Q, in late November.
While rivals like AWS offer generative AI platforms compatible with several major language models (LLMs) from Anthropic, Cohere, Meta and more, Microsoft has set its sights on OpenAI.
That made solving the OpenAI crisis essential to its immediate future. So far, CEO Satya Nadella has passed the milestone.
"Nadella is a chess master," Luria said. "This will be a chapter in Satya Nadella's authorized biography... He continues to do all this with humility. There is never the pomp and circumstance that you see in many other technology leaders."
Tola Capital partner Sheila Gulati, a former Microsoft executive who worked with Nadella for years, credits Nadella's leadership style for successfully navigating the OpenAI drama.
"His style is to get along with the rest of the team, to be collaborative, to be consultative and helpful, and I'm going to listen - and listen deeply," Gulati said. "He wants to get the best out of you and then he is decisive."
Making a sharp left turn from OpenAI now would be fraught with challenges. Even the immediate solution Nadella came up with - hiring Altman and OpenAI president Greg Brockman directly - was not without complications.
"Microsoft could have just hired anyone... [but] building something new is still difficult," says Luria.
Ultimately, Microsoft chose OpenAI for its top dog status, but it may have to diversify sooner or later, especially if the competition catches up.
"Right now they've paired their star with the leader, and that's to their advantage," Sosnick said. "The question now is whether OpenAI can maintain that status... They have made a huge investment in an unconventional organization and that comes with risks."
Persistent concerns
Going forward, concerns about OpenAI will be front and center for shareholders. First, as with many large AI startups, there are fears about bubbles and valuations.
"I think there is a realization that a bubble exists, and that could create fear or encourage investors to expand the bubble further," said PitchBook analyst Brendan Burke.
Traditional valuation metrics have flown out the window. Prior to the governance drama, OpenAI was reportedly looking for an $86 billion valuation, having raised a $29 billion valuation in April.
A source told Yahoo Finance that OpenAI shares were among the most in-demand stocks on the secondary market before the boardroom drama. When Altman's departure was first announced, transaction volume dropped.
That kind of steep decline is only something the source has seen in relatively unflattering situations, like FTX and WeWork.
While OpenAI's value has recovered - the source said secondary transactions now give the company an implied valuation of $100 billion - buyer interest is only about half of what it was in early November. Some of the demand has been channeled to other AI startups such as Anthropic and Cohere; Microsoft has not made its platform compatible with their LLMs.
But OpenAI's asterisks and assets are now Microsoft's problem.
The two companies are linked in a union that looks strangely like a couple who had a shotgun wedding. They get to know each other in the aftermath of the honeymoon, and are semi-literally trapped, for richer and for poorer, and in sickness and in health.
"There are natural limits to growth in a company as big as Microsoft, so if finding growth requires doing things in an unusual way, then they have to do that," Sosnick said.
"But the risk is ultimately the same as with any innovator in any technology: rivals can sneak up on you by doing it in a better way... Yes, diversification can help, but if you team up with five also-rans, that helps neither do you," Sosnick said.
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