The marrying of technical analysis with the traditional fundamental take on investing allows for low-risk entries. The ability to make timely entries into a security significantly enhances the overall profit of a position. The article below will discuss the technical and fundamental case for Microsoft (NASDAQ:MSFT) in light of its recent quarterly results.
Breakout to New Highs
The daily chart on MSFT neatly traces out a double bottom as evidenced by the "W" formation with the top of the pattern beginning in early April. The earnings report served as a catalyst for the massive gap down evident with the first portion of the W forming at the end of April. A flash alert was sent out to subscribers of the Undervalued Gems Investment Service highlighting the low-risk entry as the stock price sell-off was overdone as evidenced by the RSI hitting a deeply oversold reading of 30. The share price did rally from its deeply oversold position right up to the beginning of June hitting the $53 mark well short of the previous highs at the $56 level. The subsequent rally up from the oversold low formed the middle portion of the W with the subsequent turbulence of the Brexit vote serving as the final leg down completing the chart pattern at the end of June.
The bottom formed on June 27th came with an RSI reading above the lows hit in April, a positive. Moreover, the MACD registered a reading at a much higher level indicating the selling pressure evident in April is absent. I interpret this signal to read the selling pressure has exhausted itself, paving the way for a new leg higher.
The recent results speak for themselves. MSFT ran up sharply heading into earnings with three total down days for the month of July leading into the all-important earnings release. MSFT managed to rally well into the gap created by the earnings miss on the chart above. The earnings report is slated to act as a catalyst to either push the stock through upward resistance or a retest of the lows is well in order.
The formation of a double bottom substantially added to the bull case, while technical analysis aids in the overall assessment of the merits of an equity purchase, there are no absolutes in investing. The earnings report came in better than expected propelling the share price well above the previous peak and on to fresh all-time highs.
The Fundamental Case for Microsoft
MSFT remains a powerhouse in the software market via its nearly ubiquitous Windows operating system in addition to productivity tools such as Excel. MSFT is a cash cow generating copious amounts of free cash flow and remains one of two companies in all of corporate US to earn the sterling triple AAA credit rating. For all of the positives mentioned above, MSFT languished for years under the less than stellar leadership on Steve Ballmer whose penchant for making mind-blowingly bad deals such as the ill-fated Nokia deal, his parting gift to incoming CEO Satya Nadella. Below is an excerpt from the original report to subscribers detailing the bullish case for MSFT.
Part 1: The CEO
A stellar management team will find new ways to surpass expectations whereas a lousy team will find new and inventive ways to disappoint. I have avoided MSFT since the 1990's specifically because the CEO to be blunt was incredibly inept. The reign of Steve Ballmer quite simply was a horror show with a multitude of strategic blunders such as the purchase of Nokia, which Satya Nadella is unwinding and the mating dance to buy Yahoo (NASDAQ: YHOO) for $53 billion that mercifully did not come to pass.
The dismissal of Ballmer set the stage for MSFT's current revival under the steady hand of Nadella. Thus far, in my view, he has proven himself to be quite adept at running the sprawling enterprise that is MSFT. The most interesting decision made under his tenure is the move to a subscription-based offering for the Office 365 software and an aggressive push into cloud computing.
The acquisition of LinkedIn (NYSE:LNKD) surprised many on the Street yet in my view highlights the fundamental difference in managerial styles between Nadella and Ballmer. Nadella is wisely looking to augment his overall enterprise offerings with LKND serving as a key point of differentiation between competing offerings. LNKD by virtue of its valuable trove of work history remains uber valuable from a recruitment perspective. Many complained the price paid is too high, yet word came out later on in the process that Marc Benioff, the well-regarded CEO of Saleforce.com (NYSE:CRM), would have bid much higher than MSFT offer if allowed to. Benioff is thought of as a visionary thinker; I take his interest as confirmation the social network holds great strategic value hence the interest. Granted, there are no guarantees the deal will bear fruit, yet the deal holds great potential.
Part 2: Subscription Based Enterprises
Coming off the heels of Adobe Systems (NASDAQ: ADBE) move to convert its highly successful creative software franchise to a subscription based model with monthly recurring revenue, the share price has moved in a virtual straight line up. The basis for the movement is simplistic yet intuitive, by spreading out the overall cost of ownership over a longer time frame revenue recognition becomes consistent and predictable instead of its traditional lumpy pattern. Previously, ADBE would receive the entire revenue upfront once on initial purchase. Depending on the end users' need, additional purchases could be several years later depriving ADBE of further sales.
MSFT is mirroring the move with the move towards an Office 365 subscription model. The current pricing for the service ranges from $5 per month to $12.50 instead of the one-time upfront payment. An additional bonus is the impact of margins. By selling directly to the consumer, ADBE and by extension MSFT will see margin expansion as a decrease in revenue sharing with third-party vendors coupled with upgrades via downloads. Businesses that exhibit the ability to expand margins combined with a more predictable revenue stream tend to warrant a much higher multiple. MSFT has yet to receive a higher multiple which is the opportunity before us.
Part 3: The Cloud
The move into cloud remains one of the biggest stories in the sector. Amazon (NASDAQ: AMZN) through its AWS division is widely considered to have the commanding lead in the field. AMZN share price continues to elevate to new highs especially once CEO Bezos decided to report separately the AWS division's revenue aside from the retail sales. Analysts are frothing the mouth with one recently stating AMZN may become the first trillion-dollar company. To say the least, ignore the hyperbole, I remain highly skeptical of this proclamation.
AWS's revenue run rate is in the $10 billion range, on par with MSFT's own Azure division. Interestingly, if you include the Office 365 unit, which is a cloud-based platform, magically MSFT vaults ahead of AMZN. Currently, the four top competitors in the field are AMZN, MSFT, the hapless IBM (NYSE:IBM) and Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG). The listing is currently in the order of share; let's look at this list from a longer term perspective of hiring and retaining talent. IBM in my view will not be able to compete successfully with the other players simply due to the current environment within the company. IBM continues to lay off talent at an alarming rate, a major negative for morale. The company will remain challenged in attracting top talent, a key in this industry. Simply put, if you are a top engineer, where would you consider starting your career? From a longer term perspective, this leaves the field to three well-heeled players. I have a hard time envisioning AWS continuing to dominate the field going forward. AMZN remains a retailer with the grandiose goal of conquering the retail sector.
MSFT remains in prime position to dominate the field going forward. A major catalyst for the share price will come when Nadella decides to break out cloud revenues separately. Keep in mind; Azure will cannibalize some of MSFT's on-site sales. Partly due to this plus the continuing push into a subscription based platform with Office 365 overall revenue growth will remain muted over the next couple of years. Revenue growth in 2016 will come in lower than in 2015 with the upside coming in 2017. The upside is a widely expected to be 2% plus expansion of overall margins which is quite meaningful when you are dealing with a company that generates over $90 billion in sales.
Finbox. io Model
(click to enlarge)
My fair value on MSFT is $63.50, comfortably higher than the current share price. The WACC (weighted average cost of capital) used is 9.5% which in my opinion is aggressive. MSFT's balance sheet has a net cash position which reduces overall leverage while simultaneously raising its discount rate or cost of capital. The business world views a net absence of debt as an inefficient use of capital in light of the virtually non-existent interest rates available. Predictably, I have a far different view that I suspect many readers will share. The absence of debt is a sign of strength. The EBITDA multiple used is lower than MSFT's 10 year range, adding a layer of safety by employing conservative numbers. In my view, you are far better off applying a more conservative valuation and receiving a "pleasant surprise" as your forecast was proven to be too pessimistic.
MSFT continues to employ the power of its core franchise to generate free cash flow in a positive manner that will continue to benefit shareholders. MSFT uses a two-step process familiar to many when it comes to returning cash to shareholders. The most direct form is the quarterly dividend of 36 cents per share. MSFT's current yield is 2.54% with an expected hike to come in the fourth quarter. The second method is the repurchase of shares via its aggressive share repurchase plan. Share repurchase programs are helpful as long as R&D remains a priority. In the case of MSFT, the cash flow generated outstrips its needs, making a share repurchase plan an entirely acceptable method of rewarding shareholders.
MSFT remains well suited for income-seeking investors looking to add technology exposure to their portfolio. Thus far, Nadella has proven himself a far more visionary CEO than his predecessor, a huge positive for MSFT's long-term prospects. The 14% return generated thus far is particularly appealing from a low risk, well-established mega-cap such as MSFT. A similar opportunity is before us detailed in my report titled "My Top Pick for 2017" available exclusively to subscribers of the Undervalued Gems Investment Service. The yield on the security highlighted in the report is comfortably in the 3% range with excellent growth and income prospects for the next couple of years. Who says you need to take on above-average risks in order to generate adequate returns. I would like to thank you for reading; I look forward to your comments.
Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.
Disclosure: I am/we are long MSFT, GOOGL.
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.