Microsoft was down nearly 15% last week after giving disappointing forward guidance. Their core Office and Windows businesses had been benefiting from the company’s move a year ago to stop supporting Windows XP which caused a PC refresh cycle. With that now in the rearview mirror, comparisons to that period don’t look as great. I have not been as enthusiastic as others on the stock as a lot of it seemed to spring from excitement around new CEO Satya Nadella and his ability to refocus the conversation away from their legacy businesses to buzzier words like the Cloud. Prior to last week’s report I had the following to say (read full post here):
It is my sense that, despite Wall Street analyst’s mixed ratings on the stock (24 Buys, 18 Holds and 4 Sells), there is a bit of pent up positive sentiment in the stock due to investor’s love affair with relatively new CEO Satya Nadella.
But once the honeymoon is over with Nadella, and we get closer to the end of the recent period of PC stabilization, investors will once again focus on the very low growth profile of the company as the stock’s P/E approaches 7 year highs, at a market multiple
It seems to be a bit of a scam when I hear pundits talk about MSFT’s tremendous success in transitioning commercial clients to their Office 365 cloud product. Despite year over year growth over 100% it is important to remember that this is not incremental revenue. This was revenue that existing clients were spending to purchase software. So it’s merely accounted for differently as a “seat” that can be renewed vs. a software license that was previously “purchased.” Also, MSFT’s annualized Commercial Cloud revenue is about $5.5 billion, only about 6% of their expected fiscal 2015 sales.
The stock was clearly re-rated last week, after trading slightly above a market multiple for the first time in a long time, the stock now trades about 13.5x expected fiscal 2016 earnings that current consensus expects to grow 15%. Given the guidance on the capital return (company said they will accelerate the remaining $31 billion of their existing buyback over the next 8 quarters, effectively doubling the buyback from $2 billion to $4 billion a quarter) I suspect given the FX headwinds (company guided to a negative 4% eps impact in current quarter) the company may need to get a bit more aggressive on the buy back from to see earning grow 15% year over year.
I would add one more point, Nadella takes over from a long time CEO, who had replaced the only other CEO (and founder) and I suspect that Nadella may move to put his own imprint on the software behemoth with some trans-formative acquisition (putting to use some of their $90 billion in cash, or 27% of their market cap, $62 billion net of debt). The only problem is that a purchase of a company like Twitter (TWTR) or Salesforce (CRM) would be expensive and dilute to earnings and not something investors would likely initially cheer. Make no mistake, after MSFT’s multiple expansion of the last couple years, 2015 will be a period of readjustment for investors, and transition for the company.
The next real identifiable catalysts (aside from earnings April 23rd) will be an analyst meeting scheduled for April 29th and I suspect the company will start to hear calls for increased capital return (the company paid a massive $32 billion special dividend in 2004) prior to the event. I expect little by way of fundamental improvement in the PC market, while lower cap-ex from energy companies may weigh on enterprise tech spending, and maybe we are back to a period where the share-holder value is created by financial engineering.
With the stock just above $40 and a monster balance sheet, 3% dividend yield I suspect the stock finds buyers, the real issue is that the company lacks catalysts and the commentary from others in the PC supply chain seems downright bad. We could be entering a cyclical downturn, but at $40, down nearly 20% from the 14 year highs, the stock does feel a tad oversold. This stock is on our radar, but I suspect it is range-bound until a new catalyst emerges.
Also, with the conclusion of the NFL season last night, I suspect many Americans might have had their last sighting of a Surface Tablets (MSFT’s sponsorship that placed the devices on sidelines in coaches, players and refs hands) until the NFL pre-season in August. Just saying.