If you think Microsoft (Nasdaq: MSFT) shares are expensive now, they are about to get even more so. Back in December, I issued a 12-month piece target of $72. But following the company's breathtaking fiscal second-quarter earnings results, I am now confident is too cheap. As such I'm raising my price target by $8 to $80 per share.
Why the price increase? For starters, Microsoft stock is currently priced at a forward P/E of just 21 based on fiscal 2017 estimates of $2.97 per share. And while that P/E is two points above the average stock in the S&P 500 index, Microsoft's recent moves suggests it deserves a much higher multiple. With growth opportunities emerging in the realm of the cloud, Internet-of-Things, smart home and a host of other areas thanks to its recent acquisitions, Microsoft stock still looks like a bargain. I'll get back to this in a moment. But let's first assess its recent earnings.
The company's aggressive move towards the cloud was the main driver of the strong top- and bottom-line beat. Not only does this lessen Microsoft's reliance on declining PC sales, but cloud businesses also generate higher margins. Revenue from the Office 365 business grew almost 50% year-over-year, while gross margins in its commercial cloud business, which includes Azure and Office 365 products sold to businesses, reached 48% during the quarter -- up two percentage points year-over-year.
"Our customers are seeing greater value and opportunity as we partner with them through their digital transformation," said CEO Satya Nadella in a statement. "Accelerating advancements in AI across our platforms and services will provide further opportunity to drive growth in the Microsoft Cloud."
Azure revenue surged 93% year-over-year (up 95% in constant currency) during the quarter. Though Microsoft provided no specific dollar amount to help break down the cloud revenue, Bernstein analysts Mark Mordler estimates Azure now generates some 20% of commercial cloud revenue, which Microsoft said was generating an "annualized run rate" just north of $14 billion, according to Barron's. This means Azure now generates quarterly revenue at around $3 billion.
Between now and 2020, worldwide spending on public cloud services is expected to soar to more than $195 billion. This is double the revenue the industry is expected to generate by the end of 2016, according to a research firm IDC.
"Cloud software will significantly outpace traditional software product delivery over the next five years, growing nearly three times faster than the software market as a whole and becoming the significant growth driver to all functional software markets," said Benjamin McGrath, senior research analyst, SaaS and Business Models. "By 2020, about half of all new business software purchases will be of service-enabled software, and cloud software will constitute more than a quarter of all software sold."
IDC is not alone in this prediction. Pacific Crest analyst Brent Bracelin forecasts public cloud spending, currently around $58 billion annually, will triple to $205 billion in the next three years. During that span, Bracelin sees spending on SaaS services to surge 20% annually, reaching $129 billion by 2020.
As Microsoft's cloud business takes up greater portions of its total revenue, Microsoft stands to secure larger pieces of the cloud pie. And Microsoft, which during the second quarter completed its blockbuster $26.2 billion acquisition of LinkedIn, now has even more ways to attract businesses to Azure. To that end, Microsoft stock should command a higher P/E of 4 to 6 points above its current valuation.
When applying a P/E of just 25 to fiscal 2018 estimates of $3.26 per share, this puts the stock's fair value at around $80. That valuation is still more than half that of Amazon, which relies on its AWS cloud platform for the bulk of its profits. And with almost $121 billion in cash on its balance sheet make more deals for growth in key areas, Microsoft, which also pays a 2.45% annual dividend yield, is a stock to own and forget about.
Risks To Consider: Much of my optimism is based on the assumption that Microsoft can continue to increase cloud market share and successfully integrate LinkedIn.
Action To Take: Microsoft should be kept on the watchlist of investors who are looking for a company with upside potential that pays a reliable dividend.
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