Microsoft shares plunged toward the end of August and have yet to fully recover, but that’s a good thing for those who think great things are ahead for the software giant. There’s still a ways to go before investors and analysts will become more constructive on the company, but one firm is now slightly less bearish on it.
Microsoft to Neutral
Bank of America Merrill Lynch analysts Kash Rangan and Scott Shiao have upgraded Microsoft from Underperform to Neutral and raised their price objective to $46 per share. They give three reasons for the upgrade. The first is the fact that Microsoft shares have underperformed the broader market so far this year. The stock has declined 5.5% year to date, compared to the NASDAQ’s 3% decline since the beginning of the year.
Here’s a round up of hedge funds’ May returns
Tyro Absolute Return Fund was down 1.5% for May. The fund's main contributors in May were Super Micro Computer, which gained 1.6%, Shyft Group, which was up 1%, and GCI Liberty, which gained 1%. Detractors in May include Recro Pharma, which fell 2.6%, index shorts and hedges, which declined 2%, and DXC Technology, which was Read More
Second, they note that the second half of fiscal 2016 brings much easier comparisons for the March and June quarters for Windows Pro. The March quarter goes against a 19% decline, while the June quarter is up against a 21% decline. And third, they say having a 3.3% dividend yield and price to earnings ratio of 14 times excluding cash are both solid defensive strategies as Microsoft deals with uncertainty.
What BAML had been looking for
The BAML team also said the things they wanted to see have come to pass, like the headwind of XP to Windows 7 has now gone by. Also they say the bullish sell-side hopes for earnings per share of $4 in fiscal 2016 have dissipated, as have the downward revisions and high hopes for there to be a PC refresh cycle with Windows 10.
They note that it’s hard to determine exactly when and where the PC market will bottom out, as it declined another 9.5% during the second quarter. The BAML analysts said the reversal of positive impacts from Windows XP and the clearing of inventory channels going into the Windows 10 release drove that decline and were both temporary.
Upside potential for Microsoft in the Cloud
Microsoft has been making progress in its shift away from a traditional software licensing model toward a Cloud-based model. One of the main parts of this transition is getting commercial Office users to shift over to Office 365 subscriptions. Rangan and Shiao note that there could be quite a difference in gross margins between these two products.
They estimate a 90%+ gross margin on commercial Office licensing and a 60%+ margin for Office 365 subscriptions. Of course if Microsoft’s margins on Office 365 continue to outperform, as recent incremental gross margins have been in excess of 70% to 80%, then Microsoft could see an even greater positive earnings per share impact than the 5 to 10 cents they’re estimating right now.
The other impact associated with a shift to the Cloud is getting non-annuity users to go to annuity. They say even in a bear case, Office’s earnings contribution could trough at 34 cents per share in fiscal 2016 and balloon up to 67 cents per share in fiscal 2018.
Still concerns for Microsoft
Of course the BAML team does still rate Microsoft at Neutral because they still have a number of concerns about the company and its stock. One of their biggest concerns is the deferral recognition of Windows 10 revenue. Another is the impact of all the free upgrades Microsoft has been handing out.
They’re also concerned about the possibility that the transition to the Cloud will take longer than expected and that expectations for 6% to 7% compound annual growth for Office might be too aggressive. Further, they see the possibility of headwinds from the Server 2003 refresh and think it might end up being similar to the headwinds faced from the Windows XP to Windows 7 refresh.
And finally, they say it will be harder to gauge Microsoft’s progress in the Cloud transition and how well Windows is doing because of the changes to its financial reporting.