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Microsoft Stock Upgraded: 3 Things You Need to Know

By Rich Smith - Oct 5, 2017 at 4:01PM

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Canaccord sees four growth drivers for Microsoft (but I only count three).

Every day, Wall Street analysts upgrade some stocks, downgrade others, and "initiate coverage" on a few more. But do these analysts even know what they're talking about? Today, we're taking one high-profile Wall Street pick and putting it under the microscope...

Investors in Microsoft (MSFT 1.80%) stock are having a good year, with their shares up more than 28% over the past 12 months -- and beating the rest of the stock market by better than 10 percentage points. But here's possibly the best news of all: Microsoft's run is not done.

At least, not according to the analysts at Canaccord Genuity. This morning, the investment banker announced it is upgrading Microsoft stock from hold to buy and assigning this $75 stock an $86 price target. Here are three reasons why.

Digital stock percentages with up and down arrows

Image source: Getty Images.

1. Azure's taking on AWS

In a write-up covered on StreetInsider.com today (requires subscription), Canaccord says that despite Microsoft's strong share performance this year, investors are still not giving Microsoft enough credit for the "virtuous cycles" it has created in its four "compelling" growth drivers.

One of these four keys is Microsoft's Azure. Mr. Softie's answer to Amazon's uber-profitable Amazon Web Services (AWS) unit, Microsoft launched its cloud-hosting Azure service in 2010, and the business has been growing rapidly since. After several restructurings, Microsoft now houses Azure within its "Intelligent Cloud" division, which is now Microsoft's fastest-growing unit, and home, too, to Microsoft's consulting and training businesses. With sales up more than 26% over the past three years (but profits up only 8%), Azure is certainly helping to drive revenue growth at the company.

Profitability, however, remains iffy.

2. Productivity is key

Another growth driver spied by Canaccord is "Office Productivity," the easiest of Microsoft's big business divisions to identify, because it gives its name to the company's productivity and business processes division. Within this division we find such products as Office 365, Skype, Outlook, OneDrive, and LinkedIn.

Microsoft's second-biggest division (out of three) by revenue, productivity is easily the company's most profitable division, earning operating profit margins in excess of 39% (according to data from S&P Global Market Intelligence). That said, profits at productivity have actually declined about 16% since 2014, declining sequentially in every year.

So here once again, we're seeing sales grow, but profits decline.

3. A Microsoft two-fer

Both of the last two businesses that Canaccord Genuity highlights as growth drivers for Microsoft are housed in the same division. "More Personal Computing" includes both the Canaccord-favored gaming (Xbox) and marketing (MSN and Bing ads) businesses, and individually licensed Windows software, Windows Phone, and Surface PCs besides.

Microsoft's largest division by revenue ($38.8 billion last year), it's also Microsoft's poorest performer by revenue growth, with sales up less than 1% over the past three years. On the plus side, although "More Personal Computing" remains Microsoft's least profitable division (21.4% operating profit margins), this unit is growing its profits faster than either of the other two, with operating profits up by nearly 48% since 2014.

Bonus thing: Summing up the parts

Reading off the same report that StreetInsider was looking at, TheFly.com notes that Canaccord is predicting that strong performance from the four (or three) business units named above will help Microsoft achieve a "sustained period of accelerating growth." But honestly, I'm not seeing it.

Overall, Microsoft's sales have grown less than 4% (that's total -- not compounded) in three years, or barely 1% a year. Operating profits are down nearly 19% (albeit still pretty amazing, with $26.2 billion in operating profits reported last year, net profit of $21.2 billion, and free cash flow of -- get this -- $31.4 billion). But while Microsoft's profits remain very strong on the bottom line, operating profit margins have declined by nearly 700 basis points in three years, from 32.1% operating profit margins in 2014 to 25.2% last year.

At a price-to-free-cash-flow ratio of 18.3, Microsoft shares remain significantly cheaper than the average stock on the S&P 500. But if profit margins continue to shrink, Microsoft is going to need a lot more sales growth just to hold its bottom line steady. With Microsoft shares up so much already, I'm not sure that prospect justifies a buy rating at this point.

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