Why Merrill Lynch Sees Microsoft Rising Another 30% or More

Recently investors have been concerned about slowing Windows Server product revenue at Microsoft Corp. (NASDAQ: MSFT), not to mention the lower-than-expected June guidance. However, one key analyst is looking past this, and sees a number of positive catalysts in fiscal 2017 for Microsoft that could lead the stock even higher.

Merrill Lynch reiterated a Buy rating for Microsoft with a $65 price target, implying an upside of 30% from the current price level. What is important to note is that this is not even the highest analyst price target (which is $70), but it still has a massive upside.

While investors are concerned about Windows Server Product declines in fiscal 2017, Merrill Lynch does not see this as a likely scenario. Assuming that server transactional revenue is down 10%, annuity roughly flat and Azure growing at 60% or more, the brokerage firm estimates that that revenue would still be up roughly 5%. For a roughly flat overall scenario, server transactional revenue would need to decline 35% year over year. And all this is before a previous product cycle with Windows Server 2016. As Merrill Lynch estimated in its previous analysis on Windows Server, a possible price increase could have an overall $3.4 billion uplift to server product revenue and would provide a third of the benefit in fiscal 2017 as three-year enterprise agreements renew resulting in a roughly $1 billion in incremental revenue annually.

In the report, Merrill Lynch detailed:

With Azure currently at a -10 to -20% incremental gross margin many investors see it as a foregone conclusion that margin improvement will likely be much farther out in the future. However, we believe that incremental gross margins could reach+5 to +10% in fiscal 2017 with an incremental $1.6 billion in revenue to roughly $4.1 billion ending fiscal 2017. While this seems like a large improvement, we note that AWS segment operating margins were roughly 14% when it was at $4.6 billion in size, and in Microsoft’s case, it has frontloaded a significant amount of investment (reaching 22 availability zones worldwide in just a few years) and should be able to achieve significant leverage as the service continues to scale off. We estimate that this increase in growth could offset as much as 5% of the transactional decline in fiscal 2017.

Windows 10 is another fiscal 2017 driver that could come into play. Looking at prior cycles, unearned revenue peaked at $2.8 billion in fiscal 2009 with the launch of Windows 7. While unearned revenue currently stands at $2.8 billion, this time it contains roughly $1 billion of Xbox Live, and if Windows 10 can spark a similar upgrade cycle, we could see further uplift to unearned revenue balances in fiscal 2017.

Shares of Microsoft were up fractionally to $50.08. The stock has a consensus analyst price target of $57.86 and a 52-week trading range of $39.72 to $56.85.

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