Why I'm Raising My Price Target On Microsoft

Includes: MSFT
by: StreetAuthority


Microsoft's relatively low forward P/E ratio does not accurately reflect its high potential growth opportunities.

Strong growth in Microsoft's Cloud segment lessens its dependence on PC sales.

A successful integration of LinkedIn could boost connectivity across Microsoft platforms.

By Richard Saintvilus

If you think Microsoft (MSFT) shares are expensive now, they are about to get even more so. Back in December, I issued a 12-month price target of $72. But following the company's breathtaking fiscal second-quarter earnings results, I am now confident it is too cheap. As such, I'm raising my price target to $80 per share.

Why the price increase? For starters, Microsoft stock is currently priced at a forward P/E multiple of just 21 based on fiscal 2017 estimates of $2.97 per share. And while that P/E multiple is two points above the average stock in the S&P 500 index, Microsoft's recent moves suggest it deserves a much higher multiple. With growth opportunities emerging in the realm of the cloud, internet-of-things, smart home and a host of other areas thanks to its recent acquisitions, Microsoft stock looks like a bargain. I'll get back to this in a moment. But let's first assess its recent earnings.

The main question heading into 2017 was to what extent Microsoft could sustain its strong cloud momentum used in 2016 to surpass Amazon.com (NASDAQ:AMZN). Microsoft answered that question with authority. In three months that ended December, the company earned $5.2 billion (rising from $5.02 billion last year), or $0.66 per share. On an adjusted basis (taking out one-time gains and costs), earnings came to $0.84 per share, which beat the consensus estimate of $0.79. Second-quarter revenue came in at $24.1 billion, while adjusted revenue was $26.1 billion, also topping Wall Street estimates.

The company's aggressive move towards the cloud was the main driver of the strong top and bottom-line beat. Not only does this reduce Microsoft's reliance on declining PC sales, but it also improves margins (cloud businesses generate higher margins). Revenue from its Office 365 business grew almost 50% year over year, while gross margins in its commercial cloud business, which includes Azure and Office 365 products sold to businesses, reached 48% during the quarter - up two percentage points year over year.

"Our customers are seeing greater value and opportunity as we partner with them through their digital transformation...Accelerating advancements in AI across our platforms and services will provide further opportunity to drive growth in the Microsoft Cloud." - CEO Satya Nadella

Azure revenue surged 93% year over year (up 95% in constant currency) during the quarter. Though Microsoft provided no specific dollar amount to help break down cloud revenue, Bernstein analyst Mark Mordler estimates Azure now generates some 20% of commercial cloud revenue, which Microsoft said was generating an "annualized run rate" just north of $14 billion, according to Barron's. This means Azure now generates quarterly revenue of around $3 billion.

Between now and 2020, worldwide spending on public cloud services is expected to soar to more than $195 billion. This is double the revenue the industry is expected to generate by the end of 2016, according to a research firm IDC.

"Cloud software will significantly outpace traditional software product delivery over the next five years, growing nearly three times faster than the software market as a whole and becoming the significant growth driver to all functional software markets...By 2020, about half of all new business software purchases will be of service-enabled software, and cloud software will constitute more than a quarter of all software sold." - Benjamin McGrath, senior research analyst, SaaS and Business Models.

IDC is not alone in this prediction. Pacific Crest analyst Brent Bracelin forecasts public cloud spending, currently around $58 billion annually, will triple to $205 billion in the next three years. During that span, Bracelin sees spending on SaaS services to surge 20% annually, reaching $129 billion by 2020.

As Microsoft's cloud business takes up a greater portion of its total revenue, Microsoft stands to secure larger pieces of the cloud pie. And Microsoft, which during the second quarter completed its blockbuster $26.2 billion acquisition of LinkedIn, now has even more ways to attract businesses to Azure. To that end, Microsoft stock should command a higher P/E multiple, possibly up to 6 points above its current valuation.

When applying a P/E multiple of just 25 to fiscal 2018 estimates of $3.26 per share, MSFT's fair value at around $80 per share. That valuation is still more than half that of Amazon, which relies on its AWS cloud platform for the bulk of its profits. And with almost $121 billion in cash on its balance sheet, Microsoft, which also pays a 2.45% annual dividend yield, is a stock to own and forget about.

Risks To Consider: Much of my optimism is based on the assumption that Microsoft can continue to increase cloud market share and successfully integrate LinkedIn.

Action To Take: Microsoft should be kept on the watch list of investors who are looking for a company with upside potential that pays a reliable dividend.

This article was originally posted on StreetAuthority.com.

Disclosure: I/we 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. I have no business relationship with any company whose stock is mentioned in this article.