Thursday, May 27, 2010

Microsoft (NASDAQ:MSFT): Corporate PC Refresh around the Corner and Multiple Product Cycle, Upgrade to Outperform - FBR

Microsoft (NASDAQ:MSFT) is getting positive comments from several firms following yesterday's sell-off, which coincidentally made Apple (NASDAQ:AAPL) the largest tech firm out there.

- FBR Capital Markets is upgrading Mr. Softee to Outperform from Market Perform with a $32 target (prev. $31) noting the co is in the midst of a massive product cycle across many of its divisions. Most importantly, they believe we are in the early stages of the corporate PC cycle refresh that should provide a boost to the company’s flagship desktop offerings (Windows 7 and Office 2010). FBR thinks the risk/reward profile is attractive given the underperformance of the shares. Microsoft shares are down 18% YTD compared to –3% for the NASDAQ and –5% for large-cap technology. Microsoft is trading at the bottom of its forward P/E range of 11x to 21x of the past five years (excluding the height of the financial crisis in late 2008 to early 2009). While concern over the European economy is valid, they believe that is represented in the stock’s underperformance over the past month. FBR thinks the risk to the call is if Europe materially worsens and spreads globally. They are raising their price target to $32 from $31 in order to reflect their increased estimates and confidence in the company’s product cycle. FBR's new $32 price target represents 14x their FY11 EPS estimate.

Massive Product Cycle—Breadth and Duration
Microsoft is in the midst of a massive product cycle with Windows 7, Windows Server 2008 R2, SQL Server 2008 R2, Windows Azure, and the upcoming releases of Office 2010, Project Natal, and Windows Phone 7. They note that every business unit should benefit from a major product release or partnership (Yahoo! search partnership). Given the timing of release and adoption of the products in this cycle, FBR believes the impact on Microsoft will be felt for the balance of CY10 and throughout CY11.

Raising estimates. FBR is raising their FY11 revenue and EPS estimates to $66.5 billion and $2.31 from $66.0 billion and $2.24. Their CY10 revenue and EPS estimates increase to $64.1 billion and $2.11 from $63.9 billion and $2.08. CY11 revenue and EPS estimates increase to $69.6 billion and $2.50 from $68.4 billion and $2.35.

- Goldman Sachs notes Microsoft shares sold off sharply on Wednesday afternoon (closing -4.1%, vs. S&P -0.6%, and large-cap tech generally down 0.5% - 1.5%). Much of the selling has been attributed to comments CEO Steve Ballmer made on Tuesday night in Asia, where he acknowledged general concerns over European contagion. While European contagion is a concern of Goldman's broadly, they note 1) Steve Ballmer’s comments were not Microsoft specific and 2) the shares underperformed large-cap tech despite having relatively lower exposure outside of the US and the backstop of several product cycles. The day furthered the stock’s ytd underperformance.

Implications
Given significant underperformance and attractive valuation levels, they are buyers of the shares. Next catalysts will be E3, the week of June 13 in LA where we will get a look at Project Natal, the innovative controller-less gaming addition; FY4Q earnings (announced in July), which should show signs of a corporate PC refresh cycle and initial Office 2010 traction; followed by the company’s analyst day, where we expect FY11 cost commentary.

Valuation remains very attractive, with the stock currently trading at a CY10E and CY11E P/E (including ESO) of 12.1X and 9.7X versus the software medians of 20.6X and 18.8X and the S&P 500 of 14.1X and 11.9X, respectively. Goldman's triangulation of historical P/E, EV/adjusted FCF/growth multiples, and DCF leads to their 12-month price target of $38, implying 52% upside potential.

- Morgan Stanley notes that in concert with their Fallen Angels report, which reveals MSFT is at their bear case of $25, coupled with recent multiple compression across the broader market, the firm is adjusting their stock risk/reward scenarios and lowering their target price to $35 (reiterates Overweight). While they understand some of the mechanics of the pullback, the "liquidity" factor, and the relative low cost to short, the stock may have overshot to the downside. Despite MSFT's projected CY11 EPS growth rate of 16.7%, the stock now trades at only 10.2x CY11 EPS, and is below 1 on a Price-to-NTM-EPS-Growth basis for the first time since Mar-09 lows. At current levels, their What's In the Price tool reflects only 1.3% terminal growth, which is unlikely.

Large cap software has been hammered over the last month on concerns about Europe, currency and more recently some "peaking" rate of change indicators. While MSFT is not immune to potential foreign weakness, the company has much less foreign exchange rate exposure than our other large cap names with both natural (OEM deals are in USD) and synthetic hedges. Ests. for FY11 look reasonably conservative given the strong product cycle, which in turn should enable MSFT to absorb macro weakness better than most. Morgan Stanley also believes MSFT is likely buying back stock at current levels. The -20% decline in the stock over the last month (vs. the Nasdaq -13% and the S&P -12%) likely overshoots the real estimate risk. With limited downside, and 40% upside to their new PT, they like the risk reward here.

Notablecalls: I suspect FBR is going to make money for their clients w/ this upgrade. The stock has gotten pummeled over the past month, down 6 pts from its $31 highs and is likely to bounce (along with the market).

Valuation looks compelling and I'm starting to hear some rumblings of an upcoming dividend. It's not something that will happen overnight but could very well be a H2:2010 event.

Trading Mr. Softee is usually a tough gig - one needs to have a lot of patience or take huge size for the 20c move to really have any impact on P&L.

Not making a trading call here but the comments are out there.

Oh and btw, have you seen Project Natal? Worth taking a look.

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