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September 7, 2011 at 4:04 PM

Sherlund back on MSFT: Buy, with $32 target

Financial analyst Rick Sherlund – who made his name covering Microsoft for Goldman Sachs – resumed coverage of the company today.

After a detour into hedge funds, Sherlund’s now at Tokyo-based Nomura, where he initiated coverage of Microsoft with a “buy” rating and a $32 price target.

Sherlund’s debut report on the stock said Microsoft’s stock is clearly undervalued, the company’s pivoting toward mobile devices and cloud services and preparing to launch new versions of its flagship products.

The report didn’t have a big effect on Microsoft’s stock today – it closed up 2 percent, at $26 – but it’s likely to influence the conversation Wall Street types have with Steve Ballmer and other executives at the company’s financial analyst meeting on Sept. 14.

Sherlund’s expecting Microsoft to grow faster than generally expected in its 2013 fiscal year as it releases Windows 8 and Office 15.

Investors are “overly pessimistic” about MSFT and there’s the potential for “multiple expansions in the stock,” he wrote.

Sherlund raised concerns about Microsoft’s future in the mature PC market, but he sees an upgrade cycle driven by Windows 8 “ultrabooks” – the term Intel’s using for ultrathin mobile laptops with long battery life, near instant startup and solid-state storage.

A few excerpts:

We believe MSFT is compelling at current levels as the company

repositions itself by addressing the convergence of touch-based

ultrabook notebooks and tablets, introduces new cloud-based services

and benefits from the coordinated launch of Windows 8 and an updated

version of the Office Suite – all with investor sentiment at negative

extremes (even our cab driver dislikes the stock).

Microsoft’s stock value is “overly pessimistic”:

But with the September analyst meeting a likely near-term benefit to investor sentiment,

we think the stock offers optionality, a potential free look at the meeting. If investors are

optimistic about the market opportunity of Windows 8 and the company’s road map for

repositioning itself for growth, then we think there is considerable room for multiple

expansions in the stock.

On mobile devices challenging the PC market:

The rapid growth of mobile devices such as tablets and smartphones, which perform many of the same operations as a PC, but have the advantage of mobility, has pressured Microsoft’s core

Windows business. While Microsoft has a dominant share of the PC operating system

market, the tablet and smartphone markets are dominated by Apple’s iOS and Google’s

Android operating systems. As users substitute mobile devices for PCs, this eats into the

high-margin revenue from Microsoft’s Windows business. Additionally, the emergence of

new form factors creates an elongated replacement cycle as customers decide which

device best suits their needs, further depressing Windows revenues. Microsoft needs

more simple, easy to download and use apps; a quicker tempo of new product releases;

and a more vibrant mobile-oriented developer ecosystem and apps marketplace.

Windows 8 should be the catalyst:

Microsoft’s strategic new version of Windows (Windows 8)

supports touch capabilities and also supports, for the first time, the ARM processor

(which is dominant on tablets and smartphones). With Windows 8, Microsoft will be

able to address the tablet market and enhance the market for a new generation of

touch-enabled notebooks, with swivel or detachable keyboards that will begin to blur

the line between a tablet and a notebook, particularly as the new ultrabooks with

Windows 8 are introduced, likely in mid-calendar 2012. There should be a healthy

Windows 8 upgrade cycle in fiscal 2013 that benefits the stock. The stock did not

respond well to the Windows 7 upgrade cycle because the Street was concerned about

Microsoft’s poor positioning for tablets and smartphones, so it is most important for the

stock that investors’ confidence in the company’s ability to grow by addressing these

markets improves. In our view, Windows 8 is the cornerstone to achieving this.

Meanwhile smartphones – not just the iPad – are hurting PC sales:

We believe the role of smartphones has been underappreciated and is likely playing a

bigger role in slowing consumer laptop sales than is reflected in the PC industry analysis,

as we discuss below. Were there no overlap in functionality with consumer notebooks,

we might conclude that this is perhaps a share-of-wallet issue (spending diversion

versus substitution), but smartphones are far less expensive and the upfront cost is

subsidized by the carriers, and there is a very substantial overlap in functionality with

notebooks for consumers, and even some business users who are more focused on

content consumption and communication than content creation.

Ultrabooks under $1,000 will drive PC upgrades in late 2012:

We believe that Windows touch capability, together with notebook hardware and software improvements delivering instant-on and always-connected capabilities plus the thin and light-weight advantages of SSD’s and improved battery life, are likely to stimulate an upgrade cycle to a new generation of Windows 8 touch-based ultrabooks. These should be priced below $1,000, accelerating adoption and driving Windows sales, particularly as Windows 8 delivers tablet-like touch capabilities for these notebooks. We envision a hybrid device, with the functionality of a Windows notebook and some of the benefits of a tablet.

This leads to a big upgrade cycle:

We anticipate a big upgrade cycle as Windows 8 ships for consumer and business

notebooks, for which the touch capabilities of Windows 8 will add value to the notebook

experience. Windows 8 will coincide with improvements on the hardware side, including

being instant-on and constantly aware, and receiving e-mail and messages like a

smartphone or 3G tablet; it will also be lighter weight and thinner by leveraging off of the

decline prices of solid state drives (SSDs), and have longer battery life.

Investors aren’t factoring in Office:

The Street does not appear to have focused on a potential new version of

Office, but this could be very beneficial to the stock, given that a new release of

Windows and a new release of Office timed to ship together would create a

potentially more robust upgrade cycle.

We expect to see the next major release of Office (we believe this is called

Office 15 internally) ship coincident with the launch of Windows 8.

Microsoft’s back in the game:

Microsoft is getting in the game, we believe. While watching from the sidelines as the PC

industry is being eroded by Apple and Android-based smartphones and tablets, Microsoft

now, it appears, has a game plan that it is executing to with 1) the upcoming launch of

Windows 8 with touch capabilities, 2) Office 15 with touch capabilities and support for

ARM, 3) new cloud synchronization and collaboration services and 4) an effort to be

relevant to developers who want to write for the largest available market (which was

Apple’s iOS first and then Android) – and what better venue to announce a new platform

for developers than the upcoming BUILD developers’ conference. We are encouraged by

what we have been able to piece together and believe the actual plan will be articulated

beginning with BUILD.

Meanwhile Sherlund calls for a bigger MSFT dividend:

The share repurchase program was substantially reduced in the past two quarters and we question whether the company might shift the use of cash more to dividends given that some shareholders would like to see a more material dividend than the current 2.5%


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