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Microsoft (MSFT) is scheduled to release fiscal fourth quarter earnings later this month. How should investors think of shares of Microsoft heading into the earnings report? To answer that question, I examined the recent news releases, operating segments, consolidated income statement, valuations and share price.

Microsoft's product refresh cycle is strong, which is showing up in the operating segment results forecast. But, the consolidated operating margins are under a bit of pressure, based on my model. That said, based on the valuations Microsoft is fairly valued to modestly overvalued. But, after modeling the share price, I conclude that Microsoft's share price could increase about 16% upside from the $34.21 level.

Another move higher would probably make Microsoft overvalued, depending on when it happens. Thus, investors could hold onto their shares and use the $38-$40 zone as a sell zone. The $30-$34 zone is an accumulation zone.

Key Risk

Microsoft reports an outstanding fourth quarter and beats my forecast causing the share price to increase substantially and valuations to decline significantly.

This section is not intended to include every risk.

Recent News

  • Microsoft is expected to release the next version of Microsoft Dynamics CRM in the fall of 2013. Dynamics CRM competes with offerings from salesforce.com. The enhanced social collaboration and connection to MarketingPilot make Dynamics more competitive in the market. Further, Microsoft enhanced the mobile capabilities, extending user access to CRM information on their favorite devices.
  • Windows 8.1 Preview is now available. The new version of Windows should feature an enhanced user experience, including the increased availability of popular apps and deeper integration of search powered by Bing. Also, the Windows Store has been completely redesigned, which is helping Windows Phones sell six times faster than the rest of the smartphone market over the past year.
  • Microsoft and Oracle announced an enterprise partnership. Customers will be able to run Oracle software, including Java, Oracle Database and Oracle WebLogic Server, on Windows Server Hyper-V and in Windows Azure.
  • Microsoft and Best Buy Co. Inc. announced a strategic partnership to create the Windows Store only at Best Buy. The store will be in 500 Best Buy locations across the United States.

Segment Analysis

Revenue from the Windows and Windows Live Division is forecast to be $19B, which is a 3.5 percent increase compared to fiscal 2012. But, operating income is forecast to decline to $10.46B as the operating margin shrinks to about 55 percent.

Server and Tools revenue is forecast to grow to $19.79B in fiscal 2013 from $18.69B in fiscal 2012. The operating margin is forecast to remain at 40 percent and operating income should be about $7.86B. By revenue, Server and Tools should be a larger operating segment than Windows and Windows Live.

The Online Services Division should continue to grow in double digits in fiscal 2013; I'm forecasting revenue to increase to $3.28B. The operating loss should shrink to about $1.18B.

Revenue from Microsoft Business Division should increase to $24.4B with an operating margin of 66 percent (same as 2012) and operating income of $16.13B. Revenue is forecast to increased just over 1 percent; the pace of revenue growth slowed relative to the 2012, 7 percent pace.

Entertainment and Devices revenue is forecast to increase to $10.33B from $9.59B, a 7.7 percent increase.

Revenue from every division is forecast to increase relative to 2012. The Entertainment and Devices, and Server and Tools are the growth engines. Also, after years of declining revenue, Windows & Windows Live should post increased revenue. The operating segments paint a bullish picture.

Consolidated Forecast & Valuations

On a consolidated basis, I am expecting revenue to be about $78B, which is a 5.8 percent increase relative to 2012. Operating income should be flat relative to 2012, excluding the goodwill impairment charge in 2012. Net income should also be flat relative to 2012. Thus, the consolidated financial performance may act as a headwind to valuation multiple expansion.

MSFTS&P 500MSFT 5Y Avg
Price/Earnings17.716.612.6
Price/Book3.72.34.5
Price/Sales3.81.53.5
Price/Cash Flow9.59.98.2
Dividend Yield %2.62.22.4

Relative to the S&P 500, Microsoft is a between fairly valued and overvalued. Relative to its 5-year average valuations, Microsoft is fairly valued. Relative to its recent trading history, Microsoft is overvalued. Consequently, I conclude that Microsoft is fairly valued to moderately overvalued.

Assuming no goodwill impairment charges in the fourth quarter, the price/earnings valuation should decrease but still be above the 5-year average. Price/book will decrease but still be above the S&P 500 average. Price/sales should decline to about the 5-year average. Thus, the fourth-quarter earnings forecast does not change my valuation opinion.

Share Price Forecast

The share price of Microsoft formed an intermediate-term high in June and is nearing a high of primary degree. Thus, to model potential entry points, we'll use the $36 level and the $40 level; I think Microsoft may make one more move higher before heading into a larger correction.

From the $36 level, a 15% correction would be $30.60 and a 20% correction would be $28.80. From the $40 level, a 15% correction would be $34 and a 25% correction would be $30. Thus, discounting potential share prices suggest the $40 level is a more likely level from which to get a correction. The $30-$34 zone is an accumulation zone, assuming market conditions at the time suggest the appropriate action is to accumulate shares.

Source: Forecasting Microsoft's Q4 And Share Price