Why "Mr. Softy" Will Continue to Rebound

Just under a year ago, Capital Wave Forecast Editor Shah Gilani said it was time to buy Microsoft Corp. (NasdaqGS: MSFT).

It was a surprising call. The once-great software giant had become a moribund also-ran, and Wall Street clearly saw no future for the Redmond, Washington-based company.

As is so often the case, Wall Street was wrong.

Microsoft shares are up 40% in the last year, and still some of the pros seem reluctant to believe in the turnaround.

But it's a new day for Microsoft. Satya Nadella is firmly in charge from the corner office. He's setting the new tone and company direction, and he announced a massive layoff last week that sent shares surging.

And now comes the payoff, as MSFT's earnings take center stage on Tuesday. All of which makes it a great time to revisit this call on Mr. Softy.

The Upside for Microsoft Is Huge

Resident tech expert Michael Robinson also believes there's more to come for Microsoft...

Lots more...

Microsoft was a true stock-market "kingmaker" throughout the 1990s. After a long stretch in stock-market purgatory, it's emerged as a "special situation" turnaround play with a hefty upside.

"You know, Bill, most investors have written this company off - or have forgotten about it altogether," Michael told me during a late-night telephone call the other day. "It's become something of a 'wallflower' stock. But Shah made a great, great call ... and I think Microsoft is going to show us something very special. The stock is up nearly 20% this year; it has a $50 billion cash hoard, and a committed dividend policy. It has a new CEO. And it just spent $7 billion in a big buyout. It's the kind of corporate turnaround play that I just love."

To understand why the pros just don't seem ready to "believe" in this rebound - and to fully grasp the opportunity at hand - we need to take a look at Microsoft's past.

A Fond Remembrance of Those Halcyon "Wintel" Days

With its Windows operating system installed on virtually all of the world's PCs - its market share peaked at about 95% - Microsoft was the personal computer revolution.

Microsoft teamed with chip giant Intel Corp. (Nasdaq: INTC) to create the "Wintel" standard, and the duo's bare-knuckled business practices made the PC market uninhabitable for any other chip-and-software standard.

Microsoft's dominance didn't stop with operating systems, either. With its Microsoft Office suite of productivity software, the Redmond tech titan did nearly the same thing in the applications market.

The result: Microsoft's shares went on a 9,000% ride during the 1990s.

Today, Microsoft continues to dominate the PC market. But the PC market is not the dominant force it once was.

With the dot-bomb implosion of 2000, the PC market began to slow. From 2001 to 2011, while the tech-heavy Nasdaq Composite Index gained 34%, Microsoft shares plunged 25%.

"If you think back, Bill, so dominant was Microsoft that it drew the attention of government anti-trust watchdogs in both the United States and the European Union," Michael said. "All the lawsuits - designed to curb Microsoft's bullying of other, smaller companies - did virtually nothing to derail the Microsoft Express. But Microsoft's mastery of its markets and the slowing growth rate in the PC market that followed the dot-bomb implosion of 2000 ended the years of eye-popping increases. The decade that followed taught Microsoft investors a very hard lesson: The market doesn't reward companies that rake in profits but show only modest rates of growth. That's why the Street has written the company off."

But we haven't and here's why....

These Catalysts Power Microsoft's Gains

Setting aside quarterly earnings buzz, we've identified four specific catalysts that will continue to power the Microsoft stock rebound. They are:

  • The change at the top (new CEO Satya Nadella).
  • Big Data and Cloud Computing.
  • The mobile revolution.
  • And the creation of a Microsoft tech "ecosystem" - akin to the one that rival Apple Inc. (Nasdaq: AAPL) has created with its iPhone, iPad, iPod and iWatch product lines, and its vision of a unified future.

Let's take a look at the four catalysts...

A New Club Member

Microsoft insider Satya Nadella was appointed CEO back on Feb. 14. And that makes him a member of a very exclusive club.

"Even though Microsoft turns 40 next year, it's only had three CEOs," Michael said. "You've got Bill Gates, Steve Ballmer, and now Nadella. That is one very exclusive group."

A native of India who grew up and was educated in the United States, Nadella is a Microsoft veteran who's not imbued with some of the perceived personality flaws of his predecessors. For instance, Nadella is very much a "people person," which is already endearing him to his management team. He thrives on success and innovation, and he's excited about change.

"When I analyze a corporate turnaround - and I know you share the same view, Bill - I prefer to see new blood at the top," Michael said. "And by 'new blood,' I'm talking about an outsider - an exec without ties to current management. That wasn't what happened here... but that's okay. In fact, in this case, I believe the Microsoft board has made a very savvy move."

While Gates is still immensely popular among the company's hefty work force, the workers understand that the company, the workers - indeed the entire corporate culture - needs to continue its transition from a pure PC play to a company that's capitalizing on the mobile wave, cloud computing and a tech "ecosystem" akin do the "unified computing" model Apple is creating.

"Nadella occupies a rare position in the technology industry," Michael said. "He is both deeply rooted in Microsoft's history and is also seen as a visionary change agent. And he has broad support from the company's roughly 100,000 workers - as well as from Gates himself."

Folks already like Nadella's decisiveness and investor focus.

In late April, he won plaudits from Wall Street when he joined a call with analysts to discuss Microsoft's quarterly earnings. It was the first time in five years that a Microsoft CEO had been present on an earnings call.

He also understands the opportunities at hand...

Like the Cloud.

Send in the Clouds

One great thing about this appointment is that Nadella is a true expert in one of Microsoft's key growth areas: Prior to his appointment, he had served as the executive vice president of Microsoft's strongly performing Cloud and Enterprise group. Under Nadella, the unit outperformed its peer group, and the overall cloud market.

It's a massive opportunity.

Market researcher Forrester says the Cloud market - where customers pay vendors to host data and applications at remote computer centers - will hit $55 billion by the end of this year. By the end of this decade, that number will climb to more than $241 billion.

Microsoft has already staked a claim.

In its recent ranking of top Cloud players, researcher Gartner gave Microsoft's Azure cloud platform a No. 2 rating. It trailed only Amazon.com Inc. (Nasdaq: AMZN). That means it finished ahead of Google Inc. (Nasdaq: GOOG), Computer Sciences Corp. (NYSE: CSC), and International Business Machines Corp. (NYSE: IBM).

And just weeks ago, Microsoft struck a key partnership with Salesforce.com Inc. (NYSE: CRM). The terms were not disclosed, but the alliance blends Salesforce's popular customer relationship management cloud app platform with Office and Windows.

"As I see it, this should give the Cloud business a further boost from its impressive fiscal 2014 third-quarter results," Michael said. "Office 365, a Cloud offering, now has an annual run-rate revenue of $2.5 billion and grew sales 100% compared with the year-ago results."

This Is a (Really) Big Deal

Much of Microsoft's current trouble stems from the fact that it missed the mobile revolution.

But it's making a heck of a comeback attempt - and the recently completed $7.2 billion acquisition of the Nokia Corp. (NYSE ADR: NOK) device business is a linchpin piece of the strategy.

The reason: It makes Microsoft a legitimate player in mobile.

It was Ballmer who made the deal, but it's Nadella who will have to make it work.

Nokia makes 90% of the mobile devices running the Windows Mobile operating system. And in the first quarter, market researcher IDC said Windows smartphones were in third place, with a 3.5% market share.

But IDC says Windows phones will see their market share grow at triple the rate of iPhones and double the growth of Google's Android operating system. Windows phones could capture as much as 6.4% of the market by 2018.

"Nadella is taking no chances here, Bill," Michael said. "He's making Windows Mobile free for smaller mobile devices. This is a savvy move, because it makes Microsoft competitive in emerging markets that are still in the early stages of smartphone adoption. Researcher IDC says that Android is now the operating system in 78% of all mobile devices worldwide. So, by copying Google's playbook and making its operating system free, Nadella hopes to see even greater growth in India, East Asia, Latin America and the Middle East. I get a really good vibe here from all this."

Copying Apple

Folks often misunderstand Apple. It's not just a device company. It's a "tech-ecosystem" player. It created all those great iDevices - and found a way to make them work together... seamlessly.

And the new unified computing strategy that we told you about earlier this month figures to take this new "ecosystem" into entirely new areas of opportunity. Shah understood this last fall, which is why he recommended Apple at the same time that he recommended Microsoft. Apple is up more than 54% right now, and we expect more to come there, too.

But we're intrigued by the Apple model because it's clear to us that Microsoft hopes to do something very similar.

That's why the hardware Microsoft makes - the Surface line of tablets, its Xbox gaming system, and now its Nokia lineup of mobile devices - figures to become ever more important to the company's ongoing turnaround. The devices can help drive "brand awareness" up and down the product family, and drive growth in the Cloud, in mobile, in software, and in products yet-to-be unveiled.

It works the other way, too: Microsoft's Cloud business can be used to drive growth in mobile, in software, or in services.

And that brings us to our forecast for "Mr. Softy."


Microsoft brings some strong financials to these growth markets.

The stock closed at $44.71 a share Friday - 28.8% above our $34.70 recommendation price.

But Michael believes there's plenty more to come.

"You're talking about a company with sterling financials, $50 billion in cash, a dividend yield of nearly 3%, and some very nice catalysts," Michael said. "The shares are trading at a forward price/earnings (P/E) ratio of 16.8 - a bit of a discount from the overall market. It has operating margins of 34% and a return on equity (ROE) of 27%. Throw in that nice dividend and you have a stock that offers us an excellent yield and the prospect of continuing price appreciation."

The stock traded at about $60 a share back in the late 1990s. That's a reasonable target.

"Bill, if Microsoft's shares just got back to their late-1990s highs in the neighborhood of about $60, we'd be looking at a profit of 44% from current levels and a gain of 73% from where Shah recommended it," Michael said. "I think these are the minimum gains we can expect to see. Given Nadella's aggressive plans for mobile and cloud computing, all that cash, and the other catalysts we've talked about today, I believe that Microsoft will continue to earn double the market returns over the next few years. This leader-turned-laggard has become a leader again."

In short, Microsoft has added some real muscle.

Mr. Softy is getting even stronger.

About the Author

Before he moved into the investment-research business in 2005, William (Bill) Patalon III spent 22 years as an award-winning financial reporter, columnist, and editor. Today he is the Executive Editor and Senior Research Analyst for Money Morning at Money Map Press.

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