Analysis: MSFT PANW

The U.S. equity markets are trading modestly lower on Thursday with general weakness across several different sectors. Despite the down day, one stock on the move higher is Microsoft (MSFT) , which was the recipient of a very bullish call by analysts at Morgan Stanley who published a note titled: "Durable EBIT Growth Plus Improved Secular Positioning Equals the Best Risk/reward in Software." To help members understand why this note is moving the stock higher on this day down, we breakdown some of the authors' key points.

"Revisiting our detail model work with new disclosures from recent results, SEC filings and conversations with the company bolsters our confidence in the Morgan Stanley forecast looking for a three-year revenue CAGR of 12% through FY21, EBIT CAGR of 16%, and GAAP EPS CAGR of 16%," the analysts wrote. They argue that the recent quarterly results, which we discussed in our Alert here, were "strong where it matters" and highlighted strength in the Commercial Cloud, which they forecast could drive about $10 billion and $12 billion in gross profit dollar growth in FY20 and FY21, respectively.

As members know from our own earnings analysis and how we reiterate weekly in our Weekly Roundup, we are very bullish on Microsoft's Hybrid opportunity. We have long believed that Azure will continue to win business from companies that look to build out multi-cloud environments, and that hybrid is the place companies go towards as it allows them to maintain critical data in house while taking advantage of the agility and scalability provided by public clouds. This has been a longer-term driver of growth we have firmly believed in. We think Morgan Stanley agrees with this view, and they see further gains to come as IT spending moves towards Hybrid Cloud solutions.

"As the IT conversation shifts from pure Public Cloud towards Hybrid Cloud architectures involving enterprises utilizing a mix of on-premise and public cloud resources," Morgan Stanley wrote, "Microsoft pulls ahead as the best secularly positioned firm in tech, in our view. Trading at 19x CY20 GAAP EPS versus a durable high-teens total return profile, shares still undervalue Microsoft's improved secular position" as it compares favorably to software peers (see Exhibit 2 below).

One of the central debates around Microsoft has been about how long can its impressive growth last? Will the law of large numbers factor in the results? Will worries of slowing IT spending and inventory gluts challenge the company's durability? Whether it be in the Commercial Business, Intelligent Cloud, or Commercial Office 365, Morgan Stanley argues that Microsoft's key secular growth drivers held up well in the recent results. And in Morgan Stanley's Exhibit below, you'll see how Server Products and Cloud Services, which contains Azure, has maintained a 20%+ growth rate for four quarters in a row. They forecast that to continue in the first half of 2019.

Valuation always matters, and Morgan Stanley also believes MSFT is one of the more attractively priced stocks amongst their coverage. Demonstrated in the Exhibit below, the company's valuation relative to growth profiles well against many companies in the software category (and for good measure, so does Palo Alto Networks (PANW) ).

Last thing we want to point out from the note is margins. The analysts did a complete refresh of their bottom-up gross margin analysis and revisited many of the company's disclosures, filings, presentations, etc. As a result, the analysts have greater confidence that operating margins can improve in each of the next few years. See more in Exhibit 6., as Morgan Stanley expands total gross margins to steadily expand to 66.3% in 2021 from 65.3% in 2018.

Bottom line: Morgan Stanley presents an argument that shows how Microsoft has developed a more durable, double-digit top line growth profile that is backed by a favorable shift of where IT dollars are moving towards. When combined with steady margin improvement, a large buyback program and a dividend yield (currently at ~1.70%), they believe the company's high-teens total return is not priced into the stock. We currently have a TWO rating on shares, but this compelling argument has made the stock more interesting in the event of a broader market pullback.