Should You Buy The Dip In Microsoft?

Summary

• MSFT stock is off 4% in the past month.
• We maintain a ~$70 price target on MSFT stock.
• The current risk-reward profile skews towards the downside.

We have been bullish on Microsoft (NASDAQ:MSFT) stock for some time. In May of 2015, we released our first bullish report on MSFT. At that time, we stated that Microsoft was positioned for substantial growth going forward as the company embraced and aggressively pursued its transition to a cloud-and-mobile based company.

Since then, the stock is up more than 47% while the S&P 500 is up a mere 14%. The out-performance can be credited to Microsoft successfully transitioning its legacy business to a cloud-focused one. Azure is booming. Office 365 is quickly turning into the go-to cloud-based work platform. All things cloud are growing rapidly at MSFT, and that has made investors bullish about the company's long-term growth prospects.

Throughout this entire run higher, we have not wavered in our confidence in MSFT. Time and time and time again, we have stated that MSFT was a buy.

MSFT data by YCharts

But that is no longer the case. Despite the recent drop in MSFT stock, we are no longer buyers. Instead, we are neutral on MSFT stock as we feel the valuation is full.

MSFT data by YCharts

This is consistent with our thinking back in January, when we put a $70 price target on MSFT stock. Our thinking was that a stock with a strong balance sheet, healthy cash flow, top-level management, and a strong and growing dividend should trade around 2x growth (on an ex-cash basis). The stock shot above our $70 price target in early June, got as high as $72, and has since fallen back to below $70.

MSFT data by YCharts

We continue to believe that MSFT stock should reasonably trade at 2x growth given the company's robust growth in cloud services. Estimates still call for roughly 10% EPS growth next year, so we believe a 20x forward multiple is fair. A 20x multiple on the consensus FY18 EPS estimate of $3.32, plus roughly $5.40 in net cash per share, gets us to a price target just shy of $72.

That is merely 4% higher than the current price, meaning we believe upside is limited due to a maxed out valuation. Moreover, the current FY18 ex-cash P/E multiple is at a 90% premium to the growth estimate, so there is significant valuation risk at these levels. In other words, we think limited reward is accompanied by a significant amount of risk at these levels.

From this standpoint, we think the stock's risk-reward profile skews towards the downside. While we remain fans of MSFT's transition story, we are no longer bullish on MSFT stock at these elevated levels. We will wait for a much larger pullback to get back in.

Analyst’s 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.