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Microsoft Stock Gets a Buy Rating: What You Need to Know

By Rich Smith - Jul 11, 2019 at 3:28PM

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The prospect of an extra $100 billion in revenue proves too good for Cowen to pass up.

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...

At $1,070 billion in market capitalization, Microsoft ( MSFT -1.97% ) stock reigns supreme as America's sole trillion-dollar company. (This week, at least. Currently, Amazon is a few pennies shy of the trillion-dollar mark, while Apple is limping along at a measly $919 billion.)

But according to one analyst, $1 trillion is only the beginning for Microsoft. This morning, investment banker Cowen & Co. announced it is initiating coverage of Microsoft shares with an outperform rating and a $150 price target.

Here's what you need to know.

Five dice labeled buy and sell on top of LCD screen displaying stock charts and numbers

Image source: Getty Images.

Growth in the right place at the right time

Just one thing explains Cowen's enthusiasm for Microsoft stock: growth. That's why Cowen believes Microsoft shares, already up 35% over the past 52 weeks, could be poised to rise even more in the years to come.

Sales at Microsoft are growing steadily, up 14% in 2018 and up another 14% year over year in Q1 2019. More important than the growth itself, however, is where it is happening. As Cowen explains, Microsoft has successfully "positioned itself in the right secular growth markets."

Specifically, it's positioned itself to grow in "productivity and business processes," the Microsoft unit housing its Office 365 commercial products, and in the "intelligent cloud," wherein lies Microsoft's Azure cloud computing business.

Over the past four years, productivity sales have grown 33% for Microsoft, and cloud sales are up 48%. That's as compared to only 10% total sales growth from 2014 to 2018 in Microsoft's better-known Windows business. Crucially, productivity and cloud are also Microsoft's two most profitable business units, boasting operating profit margin of nearly 36% each. Personal computing, by contrast (e.g., Windows), although still Microsoft's biggest business by revenue, earns only a 25% operating margin -- a respectable number to be sure, but nowhere near as profitable as productivity and cloud.

$100 billion

Thanks to Microsoft's success in growing in these two key areas, sales at the software giant topped $118 billion last year. But here's the real kicker: According to Cowen, continued growth in these businesses is likely to add another $100 billion in "incremental" high-margin sales to the company's top line between now and fiscal year 2025.

(To be clear, this does not mean that Microsoft will generate $118 billion + $100 billion = $218 billion in 2025. What it does mean is that that over the next six years, the company would add a total of $100 billion in additional sales on top of the $118 billion a year in business it's already doing. For example, sales might grow by $12 billion in 2020, then by another $13 billion in 2021, $15 billion in 2022, and so on.)

Assuming the analyst is right about this, Microsoft could be "driving consistent double digit earnings growth" from now through 2025, says Cowen. And this prediction is in line with the average analyst estimate, which according to S&P Global Market Intelligence, forecasts 12% compounded earnings growth for the company over the next five or so years.

What it means for investors

Of course, the question investors need to ask themselves is: Is this enough? Is 12% earnings growth fast enough to justify Microsoft's current valuation of 30 times earnings?

Much as it would be nice to think so, I'm not so sure it is enough -- and to be honest, I'm not sure Cowen is 100% convinced, either, despite its shiny new buy rating.

After all, most value investors would probably agree that 30 times earnings is a pretty high multiple to be paying for 12% growth. What's more -- and somewhat unusual for a large software company -- Microsoft currently isn't even generating as much free cash flow as it reports as net income. Over the last 12 months, for example, S&P Global data puts Microsoft's cash profits at only $33.7 billion -- 3% below reported earnings, or low enough to raise its price-to-free-cash-flow ratio to nearly 32.

Admittedly, strong sales growth in its two most profitable segments could result in Microsoft growing earnings (and free cash flow) faster than analysts predict. But it's not exactly a secret that the company is finding strong profit margins in the cloud. I'd think it just as likely that over time, Microsoft's strong profits will attract more competition seeking to claim those high profit margins for themselves, sparking price wars that will reduce profit margins for all involved. Maybe this is why, even as Cowen recommended buying Microsoft shares today, it set a price target of $150 -- less than 8% upside from current prices.

Investors considering following Cowen's advice might want to keep this in mind: The next 8% profit in Microsoft stock might not be as easy to come by as the last 35 percentage points were.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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