Microsoft Has Further Room To Rally

Jan.24.14 | About: Microsoft Corporation (MSFT)

Shares of Microsoft (NASDAQ:MSFT) rallied 3.5% on Thursday after the company released a very positive quarterly report (press release available here). This quarter was likely CEO Steve Ballmer's last, and he finished his tenure on a high note. In fact, he may have left some investors wondering why they were so eager for him to leave. In the quarter, the company earned $0.78, which bested expectations by a dime, while revenue of $24.52 billion (which was up over 14% from last year) beat estimates by a strong $850 million. Shares had lost some momentum over the past two months as it was announced Ford (NYSE:F) CEO Alan Mulally would not be Ballmer's successor, but this report has given them a solid lift. Still, Microsoft shares have much further to go and should trade appreciably above $40 in coming months.

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Let's begin with Microsoft's "Device and Consumer Hardware" unit, which performed well in the quarter thanks to the launch of the Xbox One. Revenue was up $1.9 billion or 68% to $4.7 billion. Xbox sales accounted for $1.2 billion of that gain. In the quarter, Microsoft sold 7.4 million consoles, which beat expectations which were closer to the 7 million level. Xbox One was only on sale for 5 weeks of the quarter, but the company moved an impressive 3.5 million units, giving it top market share in December. Microsoft has made a big bet on the Xbox One in the hopes of making it more than a gaming system, but an entertainment platform that will entrench the company in consumers' living rooms. Xbox One sales are strong, and it is now up to the company to leverage that to further interaction with consumers.

The Surface results remain challenged. Revenue from Surface devices more than doubled to $893 million, thanks to the launch of second generation tablets. While a doubling in sales is never a bad thing, sales doubled off a small base. After all, Apple (NASDAQ:AAPL) likely generated more than 10x that revenue from its iPads in the quarter. Surface sales are growing, but represent a very small slice of the tablet market. Moreover, the Surface is still running a loss, with a cost of revenue of $932 million. Surface sales are heading in the right direction, but there remains a long way to go before Microsoft becomes a formidable and profitable player in tablets. As Microsoft take over Nokia's (NYSE:NOK) phone unit, the company will be focusing more on consumer hardware. With a stronger presence in smartphones, Microsoft should be able to increase its sales of the Surface. While this unit isn't profitable yet, it should be in the next 3 years when Microsoft should be a major consumer hardware firm.

Microsoft's consumer licensing business was down 6% year-over-year to $5.4 billion, which is driven by declining PC sales. Overall consumer Windows revenue was down 3%, while Office consumer revenue was down 24%. The consumer PC market is weak; it is as simple as that. As a consequence, Windows revenue is likely going to continue its downward trend. Signs are pointing to a less-bad year in PCs in 2014, which will help to arrest the decline. Windows does remain extremely profitable with a gross margin of $5 billion, which accounts for over 30.5% of the entire company's gross margin. This business is best viewed as an annuity that spins off cash, which can be used to fund growth projects, buybacks, and dividends.

On the other hand, Microsoft's enterprise units performed exceptionally well. Commercial licensing revenue was up 7% to $10.89 billion thanks to stronger server and Office licenses with 11% and 5% growth. Enterprise PC demand has been far more resilient than in the consumer space, as PCs still have essential business functionalities that tablets lack. While the consumer PC market is very soft and dragging on Windows revenue, enterprise continues to be a strong point for the company and should continue moderate growth over the next three years. Microsoft's "new IT" services showed strong growth, with revenue up 28% to $1.78 billion. Most impressively, cloud revenue was up 107% to $315 million. Microsoft is entrenched in enterprise and has maintained its status as an innovator, which will continue to power strong growth.

This quarter was unambiguously strong for Microsoft. Consumer hardware continues to grow, and tablets sales will benefit from the Nokia acquisition. Consumer Windows sales are weak thanks to a soft PC market. On the other hand, enterprise is fantastic with stronger PC demand and wise investments in the cloud. After this quarter, Microsoft is on pace to earn at least $2.75 in 2014, which gives shares a multiple of 13.6x. This is in addition to a 3.11% dividend, which MSFT is committed to increase. While that valuation may seem mildly attractive, it is important to recognize that the firm has a massive cash hoard. It has cash of $84 billion on hand, with $20.6 billion in debt. Ex-cash, shares have a multiple of 10.8x. With improving operations, I would be willing to pay 13.5-15x earnings on an ex-cash basis, which translates to a share price of $44.75-$49. Even after this pop, Microsoft is an attractive long.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.