MorningWord 6/27/13: Despite Eye-Popping YTD Performance, What Has Fundamentally Changed for $MSFT?

by Dan June 27, 2013 9:02 am • Commentary

MorningWord 6/27/13:  MSFT is holding their developers conference this week with much of the focus on Windows enabled devices, the convergence of devices, services to be used on devices and their roll-out of Windows 8.1.  While this event was not geared towards investors, Wall Street analysts spend a bit of time parsing through attendees’ feedback and media reports of different products/services in a hope to glean the potential for future success with MSFT’s plans to become less dependent on the desktop and the data-center as they re-situate towards the cloud.

MSFT is not a stock that we have been a fan of, largely because of their poor positioning in what is becoming an increasingly mobile computing environment for consumers, and an increasingly cloud-centric enterprise environment.  We have always acknowledged that their strong cash flow generation, huge pile of cash on their balance sheet (~25% of their market cap), monster share repurchase, valuation below market multiple and 2.68% dividend yield make it attractive to value investors.  And until late April of this year, none of that mattered, the stock was left for dead.  I do believe there were a couple factors at work that created a sort of perfect storm for the bulls:  1) investors’ search for yield when the yield on the 10 year treasury was almost 1% lower than where it is today;  2) investors’ interest in perceived cheap cyclicals that have lagged the broad market; 3)  some mildly improved visibility into MSFT’s push into software as a service for Office 365.

After what has been a long slumber, MSFT shares have broken to the high-end of the 10 year range, with ytd gains of 28.5%, dramatically outperforming most every large cap tech peer and well most every risk asset in the world.

MSFT 10 yr chart from Bloomberg
MSFT 10 yr chart from Bloomberg

We have resisted trying to fade this rally as many of the reasons for value or rotational buyers still exist, but I would suggest with the stock’s dividend yield in line with that of the 10 year treasury, investors will now once again have to focus on the company’s underlying business, potential growth and handicap what dumb multi-billion acquisition comes next.

Bernstein Research analyst Mark Moerdler who rates the shares Buy with a 12 month price target of $42 (from a note to clients this morning) believes MSFT’s:

current share price embeds an unrealistically  bad scenario of no to negative perpetual growth, billions of dollars of annual cash drain from Search and  Mobile into perpetuity, and tens of billions of dollars of additional value destruction through ill-fated  acquisitions and investments. Instead, we believe that the move of Microsoft’s enterprise business to the  cloud will generate significant revenue and EPS upside and will more than replace, over time, weakness or problems with Windows

I think this is pretty hilarious, and I think in order for the stock to continue to move higher it will have to do so on pure multiple expansion, which at this point and after the run in the stock and the broad market within a few % of the all time highs, seems fairly unlikely.  Will investors really pay a market multiple for a utility like MSFT, a company that is destined to grow earnings and sales (on avg)  at single digits for perpetuity?  I think unlikely. I mean, come on, search is a disaster, Surface is a disaster, smart-phone strategy is a disaster and if they consumer Office 365 transition doesn’t work against free competition from GOOG, they could really be screwed.

One thing that struck me as kind of interesting is that yesterday on CNBC’s Fast Money Halftime when the panelists were asked for their views on MSFT all were Bullish, even our very own Enis Taner (albeit purely on the yield and value front, not on core business) and one of the panelists went as far to suggest that this week’s conference shows that the company has awakened from its innovation drought.  I highly doubt that.  Xbox may be cool but its sales don’t really move the needle on the company’s ~$80 billion in sales (entertainment and devices was ~12% of last quarter’s sales).

This continued bullish sentiment, right as the stock has lost of bit of momentum could set up for a decent short entry if the stock is unable to make a push and close above recent resistance at $35.  The one year chart below shows what could have been a sort of rounding top btwn $35 and $36 since mid May, and I would be targeting a move back to $32 which could serve as decent 1 year support.

MSFT 1 yr chart from Bloomberg
MSFT 1 yr chart from Bloomberg


The next identifiable catalyst for the stock will be fiscal Q4 earnings scheduled for July 18 after the close which falls in July options expiration.