Strengthening secular positioning and a return to double-digit EPS growth (+11% YTD) for Microsoft Corporation (NASDAQ:MSFT) should afford investors increased confidence in the durability of mid-teens total return. With M&A and FX impacts now in numbers, EPS ests are poised to move higher. Morgan Stanley expects MSFT to resume an upward trajectory.
With a strengthening secular positioning and rationalization of underperforming portions of the solution portfolio, Microsoft is back to showing durable double digit EPS growth — and investors should be willing to pay a higher multiple for that growth. Through the first half of FY17, the stock digested impacts from the acquisition of LinkedIn, a higher tax rate and modest FX headwinds, and now is positioned for continued positive EPS revisions. The firm's recent work on Microsoft has focused largely on the equation for a durable mid-teens total return profile. In this report, it presents three arguments for why investors should be willing to pay a higher multiple for that return profile. On the back of a 10% higher P/E multiple,22X versus 20X, and the firm's above consensus forecast of $3.66 in CY18 EPS, the firm moves its price target to $80.
Microsoft's current trading premium of 16% to the S&P 500 is in line with its premium over the last two years; however, its current total return profile (CY16 to CY18 EPS CAGR plus current dividend yield) is at a ~50% premium. The firm believes Microsoft's multiple can move higher given the durability of double-digit EPS growth and a premium total return relative to the S&P 500.
In Morgan Stanley's report Global Technology: Public Cloud, What’s It Worth? (15 Mar 2017), the firm estimated a ~$250 billion valuation for Microsoft's cloud businesses alone (Office 365, Azure and Dynamics). This valued the remaining businesses at Microsoft at just 7x EV/FCF with the stock at $65. Updating this metric for the increase in stock price to ~$70 today and using CY18 FCFs, while keeping the value of the cloud unchanged at ~$250B, implies the non-cloud assets trade at just 8x EV/CY18 FCF. The firm sees two avenues of upside from this perspective:
1) Upside from the Cloud: The firm's report Microsoft: Still Seeing Upside in the Cloud (04 Apr 2017) outlines three avenues of upside to its base case cloud forecast – broader adoption of Azure, increased monetization within O365 and Machine Learning expanding the overall market. These elements drive the firm's bull case cloud view, and would add ~$110 billion in enterprise value. More discretely, LinkedIn was not included in the original Cloud analysis. Adding this $4+ billion revenue base to the original analysis adds an incremental ~$25-30 billion in enterprise value.
2) Non-Cloud Assets Worth More than 8x: The non-Cloud portion of the portfolio should be valued at more than 8xFCF. While slow growing, there are some strong growth assets in the portfolio – Xbox, Bing, Surface – and the legacy components have proven more durable than many feared – on premise Server & Tools has sustained mid-single digit growth over the past year and PC OEM business is relatively flat. Comparing to legacy, low growth peers in software, like Oracle, would suggest a FCF multiple closer to 12x, which would add another ~$115 billion in EV.
Microsoft is the only name in the firm's software coverage group that reports a GAAP EPS number. While one would hope investors would account for this in the multiple they are willing to pay for the stock, the negative impacts from including the amortization of intangibles from LinkedIn (an element normally taken out of non-GAAP EPS), translated into muted stock performance for Microsoft coming out of Q2results. On a FCF basis, Microsoft looks more favorable relative to software and large cap tech peers. The upcoming adoption of ASC 606 across the industry, which further reduces comparability of earnings, may push more investors to look towards an EV/FCF multiple.