Manager. Microsoft (MSFT) Identifying Stocks Poised to Outperform

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Managing Director Microsoft (MSFT) Identifying Stocks Poised to

1 3 Manager Using ZRS and the Zacks Valuation Model to identify factors impacting equity valuations in 3 minutes or less Tim Nyland, CFA Managing Director Microsoft (MSFT) Identifying Stocks Poised to Outperform September 30, 2016 Zacks Professional Services (866) zrs@zacks.com

This expectation of excellence is rooted in spectacular top and bottom line growth, innovation in technology, and strong leadership.

2 Microsoft Few companies have enjoyed the magnitude of success Microsoft has over several decades and only one is led by the world s richest man. Microsoft s success has grown from an accomplishment to an expectation of excellence. This expectation of excellence is rooted in spectacular top and bottom line growth, innovation in technology, and strong leadership. Although strong leadership is a debatable concept, growth and innovation are more easily quantified. In the Ricardian model, variances in labor productivity can be attributed to underlying differences in technology, and are the foundation of comparative advantage. Innovation in technology has helped drive Microsoft to be a leader among its industry in margin growth and sales. In 2000, Microsoft experienced a considerable blow due to the anti-trust movement against the company and the bursting of the tech bubble. Since then, the company experienced 12 years of sideways moving prices followed by 4 years of booming growth resulting in an all-time high stock price.

3 It is important to ask; what is the fundamental cause of the recent price growth despite being annexed under the $30 mark and is it warranted? The following chart is a representation of a Microsoft shareholder s return between 8/2011 to 8/2016 versus the S&P 500: How was Microsoft able to achieve such uniformity in return? When it comes to things as uncertain as the stock market, people bet on consistency. Consistency in dividend growth. Consistency in earnings earnings have remained persistently smooth and estimates show potential for further growth. Consistency in revenues revenues have steadily grown year over year from 2011 to 2015 and are estimated to continue a strong growth pattern.

4 It is clear that Microsoft is currently operating at near all-time low margins. This margin contraction can be heavily attributed to R&D and marketing expenses. These expenses may prove to be a good investment for future revenue and earnings growth.

Not if, but when a margin expansion occurs; earnings and gross profit will generously reflect those fluctuations.

5 Despite the margin constriction, this is no reflection upon Microsoft as it is not the exclusive bearer of margin issues. It is important to recognize that the Computer Software-Services Industry as a whole is on the tail-end of this contraction in margins. Not if, but when a margin expansion occurs; earnings and gross profit will generously reflect those fluctuations. According to the Zacks Digest Report, the majority of analysts expect margins to increase in the upcoming quarter driven by expectations of higher revenues. Revenue (aggregate and per share) is forecasted to recover in a major way over the following 12-month period. Once margin contraction tapers off, earnings may also see such growth.

What does all of this mean? The buy side is currently pegging EPS growth, market implied growth rate, at 8.43% while the sell side is standing behind a more conservative 7.73% EPS growth.

From 2008 to 2013, as the price and earnings (EPS*10) lines intersected, Microsoft was trading at a P/E multiple of 10 which marked a period of cyclical growth.

6 What does all of this mean? The buy side is currently pegging EPS growth, market implied growth rate, at 8.43% while the sell side is standing behind a more conservative 7.73% EPS growth. Analysts have forecasted strong and growing normalized earnings and a surge in EPS estimates. From 2008 to 2013, as the price and earnings (EPS*10) lines intersected, Microsoft was trading at a P/E multiple of 10 which marked a period of cyclical growth. In the recent 3 years, Microsoft has enjoyed an EPS multiple expansion. A noticeable trend is that price growth is outpacing EPS growth suggesting that the investment community is placing a bid of confidence in the stock and signaling potential outperformance and EPS surprise in the future. On a least squared growth rate basis, Microsoft has recently seen a period of revenue regression. On the other hand, EPS has seen a strong year of growth and will likely continue the trend in the future. In addition, Microsoft is also predicted to begin its process of improving revenue. Improvement in revenue will strongly affect the revenue growth stagnation seen above. Microsoft, primarily fueled by their cloud product Azure, is set to collect on a high balance of unearned revenue in the upcoming two quarters which will spike revenue growth.

7 The market implied EPS growth rate of the company is 8.43%. In the past, Microsoft has reliably posted positive EPS surprises 16 out of 21 times. The potential margin expansion outlined above in addition to a steady dividend payment leads me to believe Microsoft is set to outperform the target. Whether or not you are sick of hearing the word, consistency is the foundation of Microsoft and translates into top and bottom line growth, steady dividend growth, and the potential for significant margin expansion; Microsoft s stock price growth is not only warranted but also may continue to outperform in the foreseeable future.

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