Strong Upside For Oracle And Microsoft

Includes: MSFT, ORCL
by: Takeover Analyst

I previously argued that the bulls are right on Oracle (NYSE:ORCL) and that Microsoft (NASDAQ:MSFT) is substantially undervalued. In light of innovations by Apple (NASDAQ:AAPL), both companies have received an unfortunate reputation of being too mature for high-growth. It is possible, however, that these companies could benefit the most from cloud services and accordingly accelerate shareholder value. While I definitely do not foresee either company's shares topping $40 any time soon, this is not outside the realm of possibility.

From a multiples perspective, the odds are more in Microsoft's favor to achieve the $40 price target. It trades cheaply at only 9.2x and 8.4x past and forward earnings, while offering a strong dividend yield of 3.2%. Oracle, on the other hand, trades high at 17.5x and 11.6x past and forward earnings, while offering a dividend yield of only 0.8%. Both companies also have healthy gross margins of around 77% and are taking the right steps now to expand this metric. The Street currently rates shares of Oracle a "strong buy" and those of Microsoft a "buy." While I share the bullish overall sentiment, I believe that the reverse should be the case.

On the first quarter earnings call, Microsoft's CEO, Peter Klein, noted strong performance:

"We’ve started fiscal year 2012 with good momentum. We have great products in the market, customer satisfaction is high, and we have important strategic investments and alliances to position us well for long-term growth.

This quarter, we saw revenue growth across all of our segments. Similar to prior periods, we continued to see broad-based demand across geographies, including Europe. Within our segments, the Microsoft Business Division continued its momentum with revenue of $5.6 billion, growth of 8%. Despite the best efforts of competitors, Office remains the overwhelming choice for productivity, evolving with our customers and posting impressive revenues."

In addition, Office 2010 received good reception and the PC attach rate to Office grew meaningfully. Integration of Skype also proceeded smoothly and although many investors believe it was a poor acquisition, I think in the long-term, it will derive many unforeseen revenue synergies. The asset is somewhat of a partnership darling, as it has the potential to be applied to a variety of different businesses.

The company also has strong potential with Office 365, a cloud service that many global businesses are starting to adopt. Windows Azure is yet another catalyst for the firm and gives clients the ability to build new applications and branch them into the private cloud. Finally, the company is developing Windows 8, which should help to win customers from Apple, as its predecessor proved enormously successful.

Consensus estimates for Microsoft's EPS are that it will grow by 2.2% to $2.75 in 2012 and then by 10.5% and 10.9% more in the following two years. If the multiple expands to 13x - below that of the market overall - and the 2013 EPS estimate is realized, the stock should technically be worth above $40. However, even if the multiple increases nominally to 10x and 2013 EPS is 7.9% lower than consensus at $2.80, the rough intrinsic value of the stock is $28. Accordingly, Microsoft, in my view, has favorable risk/reward.

Ditto for Oracle, despite what I see as aggressive top-line guidance. Oracle stands to particularly benefit from margin expansion. During the first quarter, hardware GMs rose by 600 bps to 54%. The software-maker stands to uniquely benefit from rising demand for mobile apps. Catalysts include Cloud Paas and its integrated apps through Fusion.

Consensus estimates for Oracle's EPS are that it will grow by 8.6% to $2.41 in 2012 and then by 10.4% and 10.5% in the following two years. Assuming a multiple of 15.5x and a conservative 2013 EPS estimate of $2.60, the rough intrinsic value of the stock is $40.30. This implies 31.1% upside and makes the company an attractive defensive play against a volatile economy.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in MSFT over the next 72 hours.