Microsoft Undervalued, Facebook's Earnings Potential And QE Will Provide More Upside

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 |  Includes: DIA, FB, MSFT, SPY
by: David Ristau

Summary

This week seems to be setting up for even more upside as the FOMC meeting will come and go this week without taper. With the government crisis and unemployment making no move at all towards the level the Fed needs, QE looks very likely to continue at its current levels. Outside of this key Fed meeting, we have a very heavy slate of data with retail sales, consumer confidence, and more employment data. Further, we continue to get earnings with keys from Apple (NASDAQ:AAPL), ExxonMobil (NYSE:XOM), Visa (NYSE:V), and Facebook (NASDAQ:FB)

Chart Overview

The S&P 500 (NYSEARCA:SPY) rebounded off support at 1650, and it has now broken all resistance. The index looks quite strong, and the new resistance for breakout is 1760. If that level breaks, it could be big for the SPY to move even higher.

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The Dow (NYSEARCA:DIA) is bouncing back but still remains the laggard. The index has had trouble getting going over 15400, and it has strong resistance 15500 and 15600. It is still going to need some more help to be more solid. The lagging blue chip earnings have hurt this index.

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Economic Data

Date

Data Report

Market Expectations

Previous Report

October 28

Industrial Production - September

0.3%

0.4%

October 28

Pending Home Sales - September

-1.3%

-1.6%

October 29

Retail Sales - September

-0.1%

0.2%

October 29

PPI - September

0.2%

0.3%

October 29

Case-Shiller 20-city Index

12.4%

12.0%

October 29

Consumer Confidence - October 29

73.1

79.7

October 30

ADP Employment Change - October

125K

166K

October 30

CPI - September

0.1%

0.1%

October 31

Challenger Job Cuts - October

N/A

19.1%

October 31

Initial Claims - 10/26

335K

350K

October 31

Chicago PMI - October

55.0

55.7

November 1

ISM Index - October

55.0

56.2

November 1

Auto/Truck Sales - October

N/A

5.4M/6.5M

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As one can see, this week is very busy for the markets. One thing that we will see with economic data is that much of the October data may end up being shrugged off by the market, as it will be called a one-time issue due to the government shutdown. With that said, there is a lot of data to watch, and it will be interesting to watch. The key reports we will be watching are Retail Sales on Tuesday that are expected to show another decline for September. PPI and CPI on Tuesday and Wednesday are key as well to see inflation information that will make a big impact on QE potential. Consumer confidence on October will be released as well on Tuesday. It is a big report to get the beat of the market in a government shutdown issue. Finally, we finish the week on Wednesday with a crucial report from ISM Index. The Index for October is also supposed to decline. Look for the SPY and DIA to have less impact from earnings, though, than the heavy slate predicts.

Foreign Markets

Outside of the USA, Europe and Asia will remain important, but with so much data and earnings on the docket, it will still be a sub-story. The crucial moments to watch are Japanese industrial production on Wednesday as well as some interest European data on the same day - German unemployment, Spanish GDP, eurozone consumer confidence. On Thursday, we get the BOJ rate decision as well as eurozone unemployment rate, and we finish the week with a key manufacturing PMI for China.

Earnings

Date

Key Company

October 28

Merck (NYSE:MRK)

October 28

Apple

October 29

Pfizer (NYSE:PFE)

October 29

Gilead Sciences (NASDAQ:GILD)

October 30

Visa

October 30

Comcast (NASDAQ:CMCSA)

October 30

Facebook

October 31

ExxonMobil

October 31

ConocoPhillips (NYSE:COP)

November 1

Chevron (NYSE:CVX)

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It is a HUGE week for earnings. The fourth week of earnings may actually be the most important. With a week removed from the shutdown, the reports will be crucial from all ten of these companies above. The most exciting reports will be from Apple, Pfizer, Visa and Facebook. The combination of ExxonMobil, COP, and Chevron will give a lot of movement to the major oil and gas industry. All these companies are going to move the market, so it's crucial to watch them.

The major report that we are most interested in watching this week is Facebook. While out of the ten, the company is the least representative of the general market, the stock is up considerably so far this year, and this earnings report could be a major moment for the stock and other high growth names. With the stock up 95% YTD and up 166% for the past twelve months, the report definitely has some potential volatility. The company sitting with a current price/earnings over 190 and future P/E over 50, the stock is definitely expensive. The question, though, is whether that value even matters. The two keys we believe investors/traders need to watch with Facebook's earnings is mobile revenue/earnings as well as the company's ad load.

Earnings and revenue growth overall are definitely important, but we believe that investors know that the only thing that matters is mobile growth in earnings and revenue. In the last quarter, mobile surpassed desktop for daily actives with 500M people using FB mobile each day. Mobile ad revenue grow 30% from Q1 with mobile ad revenue growing to 41% of total ad revenue. Expectations for mobile ad revenue are $790M up 20% quarter/quarter and 46% of total ad revenue. Those numbers are the ones to watch. Ad load, additionally, is very important. The company had an ad load at 1-to-20 in Q2, but others believe this has more upside. Ad load simply means how often ads show up on Facebook mobile. 1-to-20 is pretty low, and there is a lot more upside in growing the margin per user.

Overall, we see no reason for downside if we continue to see mobile revenue grow and ad load grow. If the company comes in above expectations, the stock will see more upside. The issue, though, is that a miss could lead to a serious correction in the short-term, but it would likely be a nice buying opportunity.

Fed Outlook

The Fed has an important role this week with its FOMC decision scheduled to come out on Wednesday. There is very little expectation of any taper due to the government crisis and latest employment data, so there is unlikely to be any issue. If they do say we are looking at some taper in the future though or even do mention it, it can definitely provide some issues for the market. QE to infinity, though, will continue to provide upside to the market.

Conclusion

We are bullish on this week, and we believe the market will see more upside from here. There is not much to expect for downside outside of earnings. The Fed will QE some more, and data will be shrugged off as it was hurt by the government shutdown. The earnings could provide some potential issues for the market, but the quantity of earnings will definitely sap some of the ability for them to have a major impact on one or two misses. Look for upside this week in the SPY and DIA.

Stock To Watch

Ticker: Microsoft (NASDAQ:MSFT)

The latest round of earnings were quite impressive from Microsoft, and the stock looks to have a lot of momentum heading out of the report and into a new era post-Ballmer. The keys to the earnings that impressed us were sales growth up 16%, quarterly profit up 17%, and some green shoots in the mobile business, which is the future.

Moving forward, the most important thing for the company is to see its cloud computing services and mobile continue to grow. In the latest quarter, cloud commercial services saw 100% growth year/year along with expansion in gross margins on the back of strong action in Office 365 and Azure. What Microsoft is doing well is they are taking their popular and best-in-class Office products and developing them into a cloud presence in the way that Google has done with their similar Office-style products. Windows Azure is also helping as the company is offering cloud solutions to build, deploy, and manage applications from Microsoft data centers. Azure is offering everything from web sites to storage to application services to virtual networks and data transfers. Azure is a powerful solution that is part of the redefined Microsoft. Azure customers grew by triple digit percentage in the latest quarter. As the company redefines itself, we believe Azure becomes even more powerful as a solution that the company can sell in sales channels:

Secondly with Azure, I think we have seen both, but the thing I would say is what has been really helpful is that as we make it easier to attach Azure services to our normal rhythm in the field for enterprise agreements and through licensing. It provides a really helpful way and a really easy selling motion to provide customers flexibility. We added in the normal rhythm of the sales motion. We allow people to try, use and buy. And that has served us well in terms of being able to expose Azure to more and more customers in a normal selling cycle. So I think that's probably one of the better ways. It's the same actual selling rhythm we have used with Office 365 so successfully.

At the end of the day, though, Microsoft still very much needs to sell their software on PCs and to PCs to consumers. Licensing software is expected to come in at $5.2 - $5.4B in Q2, which is a nice improvement over the $4.3B in Q1. Consumer licensing is going to remain volatile the company noted. Gartner, though, has noted that PC shipments fell 8% in Q3, but the company can make up for these issues as Windows Phone is included in their consumer licensing. Microsoft has seen their market share of smartphone platforms grow from 3.0% to 3.2% in the latest data from ComScore. Additionally, Microsoft sites ranked 7th on top 15 properties with 46% reach for smartphone users.

We wanted to take the latest earnings and help craft them into a pricing to see just how much value is available in shares. The company is expected to see Licensing at $5.2-$5.4B in revenue. Hardware will have a big lift due to Xbox One to $3.8B - $4.1B. Devices and Other Consumer sector will see $1.7B - $1.8B. Commercial licensing will be at $10.7B - $10.9B, and other Commercial will be at $1.7 - $1.9B. The company expects operating expenses to come in at $8.5-$8.6B in the quarter and around $31B in the full year. Full year capex is supposed to be $6.5B. Taxes are expected to be at 18%-20%. Full year expectations are for revenue to be around $84B. With operating expenses expected to be at $31B and cost of revenue to be around $24B, operating margin should stay around 34.5%. In the model, we use a very low growth level for 2016-2018 to put the emphasis on this cycle and to show how much value is in shares right now.

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2013 Projections

2014 Projections

2015 Projections

2016 Projections

2017 Projections

Operating Income

29000

30885

32450

33400

34000

Taxes

5800

6177

6490

6680

6800

Depreciation

4000

4250

4500

4750

4800

Capital Expendit.

-6500

-5000

-5500

-5750

-6000

Working Capital

6500

6500

6500

6500

6500

Available Cash Flow

14200

17458

18460

19220

19500

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Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012). WACC for MSFT: 7.12%

2013

2014

2015

2016

2017

PV Factor of WACC

0.9334

0.8714

0.8136

0.7595

*

PV of Available Cash Flow

13256

15214

15018

14597

*

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Step 3.

For the fifth year, we calculate a residual calculation. Taking the fifth year available cash flow and dividing by the cap rate, which is calculated by WACC subtracting out residual growth rate, calculate this number. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. Cap Rate for MSFT: 4.1%

2017

Available Cash Flow

19500

Divided by Cap Rate

4.1%

Residual Value

473301

Multiply by 20167PV Factor

0.7595

PV of Residual Value

359464

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Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows

58086

PV of Residual Value

359464

Cash/Cash Equivalents

4023

Interest Bearing Debt

15930

Equity Value

405643

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Step 5.

Divide equity value by shares outstanding:

Equity Value

405643

Shares Outstanding

8350

Price Target

$49

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Therefore, we can see using a fairly unaggressive model that uses a 4.1% cap rate shows a lot of upside. That makes sense given the future PE is at 10.0 and PEG at 1.7. Right now, we like MSFT after these earnings for a strong cycle over the next two years.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Business relationship disclosure: I have no business relationship with any company whose stock is mentioned in this article. The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.