The Microsoft Corporation Have Upgraded To Buy At Merrill Lynch

Recently, an updated note sent to investors and clients on Friday, Merrill Lynch has upgraded Microsoft rating from Neutral to Buy along with a price objective (PO) of $63 that shows around 37% increment from its last PO of $46. The latest upgrade follows Microsoft’s earnings call yesterday for its third quarter fiscal year 2015 (Q3FY15), which highlights several astonishing results about the company that will likely result in an increased investor confidence.
Merrill Lynch on October 1, upgraded its rating from Underperform to Neutral citing positive drivers such as improved year-to-date (YTD) stock performance versus NASDAQ, and defensive characteristics in an uncertain market. Another contribution was the view that XP refresh headwinds move to fade with easy Win Pro comps to look ahead to in March and June quarters.


The latest earnings release has reflected several positive catalysts that have resulted in another upgrade to rating. These include the turn in operating income towards growth after four consecutive years of flat results as evidenced by the 11% growth year-over-year (YoY), and gross margin growth of 250 basis points (bp) that again shows a reversal from YoY declining trend in the last few years. COGS has also declined for the first materially by around 13% YoY. With all this, another key driver firm believes is the good quality revenue growth that is achieved from not just low-margin hardware growth but also from software and GM improvement.
There continuously have been downward earnings per share (EPS) revisions since Microsoft was not able to beat estimates and was struck in the $40-49 range since past 18 months. This time, however, the company has come up with strong fundamentals and the research firm has estimated a 5% above consensus EPS of $3.5 for 2018. The increasing concerns for cloud business are also eased by the 85% incremental gross margin shown by commercial cloud along with the 135% YoY growth of the lower-margin Azure. The business is now track with the AWS’ 25% operating margin to be the next benchmark.
The research believes that Azure has a capability to generate around $2 billion operating income in FY18 with 25% operating margin that will help to push cloud segment to $13 billion gross profit in 2018. Another reversal from the decline is shown by office products and other cloud services as evidenced by the positive 5% CC. The firm states that office products trends are getting considerably less negative and the combination of cloud margins with office growth will likely put the company in a position to achieve the 2018 EPS estimate.
The PO of $63 is based on 16 times FY18 EPS plus net cash per share. EPS for 2016 and 2017 are estimated to be $2.55 and $2.95, respectively. While revenue and margins are expected to increase in future, return on equity (ROE) is expected to slightly decline. With such valuations, the risks pointed out include impact of free Windows 10 and seemingly aggressive expectations for Office seat growth around 7% CAGR over FY15-18.
Out of the 34 analysts covering Microsoft stock, 19 suggest a Buy, 11 recommend a Hold while the rest give a Sell rating. While the 12 month consensus price is $50.45, the stock currently trades in green, up 10.34% at $52.99. The stock has gone up by around 13% since last 12 months compared to the NASDAQ Index that has gone up by around 5%.