MorningWord 5/18/15: $MSFT – Cloudy With a Chance of Salesforce

by Dan May 18, 2015 9:46 am • Commentary

Over the past year shares of Microsoft (MSFT) have been volatile, gaining, then losing, and then gaining again nearly $75 billion in market cap:

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

That is a fairly astounding range when you consider the fact that there are only about 60 companies in the S&P 500 that have market caps greater than $75 billion. (That’s basically the current market value of Starbucks)

The volatility is a direct result of the push and pull between the competing forces of the company’s old tech moniker and investor hope for future growth. There’s the optimism surrounding the new CEO’s plan to re-energize the company with new-fangled ways to charge for software that should result in increased revenue growth and the company’s ability to chart a course back to double digit earnings and revenue growth.

In Fridays Barron’s Tech Trader Daily, Tiernan Ray detailed a bullish MSFT note from Bernstein software analyst Mark Moerdler highlighting “factors in favor of the company are a pick-up in growth — 11% revenue growth in fiscal ’16 and 15% in fiscal ’17 — and improving profit margin and rising capital returns”:

Accelerating revenue growth, driven by a shift to subscription-based licensing, new cloud and mobile offerings, and strong growth in enterprise business. Margins should improve as the new management team continues to streamline the company to be more efficient, even when accounting for the Nokia acquisition. Increased return of capital, driven by several new board members who we believe are much more likely to issue debt (secured by overseas cash) to fund larger buybacks.

As for driver of future growth, look no further than MSFT’s  “commercial cloud” offerings. From Moerdler:

We estimate that the $20B in commercial Cloud revenue in FY18 conservatively includes $9.3B in new revenue and $10.7B in license revenue that transitions to Cloud revenue. We estimated that 78% of commercial Cloud revenue today is from Office 365, 15% from Azure and 7% from Dynamics CRM and other commercial Cloud sources, most of which are in their infancy but could be significant in the future. This is a combination of new revenue sources for Microsoft and existing revenues have transitioned.

You know the drill, buybacks, div yield of 2.6%, commitment to do more, huge cash generation, currently $95 billion in cash ($64 net of debt), new CEO, new plan etc etc.

Seems like a layup, no?  Well, there have been rumors of transformative acquisitions and recently chatter about SalesForce (CRM). The two CEOs seem chummy. But a deal of this magnitude could be the single largest factor in Nadella’s honeymoon ending abruptly.  If analysts think that commercial cloud sales can be 20% of total sales in a couple years, with half that incremental and with MSFT having an existing strategic partnership with CRM, why do such a deal unless you feared CRM could be gobbled up by a competitor?

Obviously there are very few companies who could pay the nearly $60 billion required to do such a deal, and in my mind seems a tad unlikely given its shear size and what would certainly be dilutive nature of such a deal.

So MSFT is just below $50. And with the stock no longer cheap on a P/E basis trading 19x current year and 17x next, I think you wait for a better entry in the low $40s.